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Working Capital Management

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Working capital management is best described as the administration of all aspects of current assets and current liabilities. It is concerned with the problems that arise in the management of current assets, current liabilities and the interrelationships that exist between them.

The primary objective of working capital management is to manage the firm’s current assets and current liabilities in such a way that the satisfactory amount of working capital is maintained i.e., it is neither inadequate nor excessive. Both inadequate and excessive working capital are dangerous. Inadequate working capital may lead to stoppage of production.

Working capital management refers to the management of current assets and current liabilities. Working capital management is a managerial strategy of maintaining efficient levels of components of working capital current assets & current liabilities. The term current assets refer to those assets, which in the ordinary course of business, turns into cash.

Working capital management is concerned with maintaining an adequate amount of working capital, which is neither excessive or inadequate. Both excess and inadequate working capitals are not good for proper functioning of any business concern. Both excess and inadequate working capitals are dangerous to business. Therefore, a business concern should maintain an adequate amount of working capital. 

Working Capital Management: Meaning, Concept, Factors, Importance, Types, Estimation, Sources, Effects, Difference, Advantages, Problems and More…

Working Capital Management – Introduction and Meaning 

Working capital management is best described as the administration of all aspects of current assets and current liabilities. It is concerned with the problems that arise in the management of current assets, current liabilities and the interrelationships that exist between them.

The primary objective of working capital management is to manage the firm’s current assets and current liabilities in such a way that the satisfactory amount of working capital is maintained i.e., it is neither inadequate nor excessive. Both inadequate and excessive working capital are dangerous. Inadequate working capital may lead to stoppage of production.

Excessive working capital may lead to carelessness about costs and therefore, to inefficiency of operations. If a firm invests more in current assets, it increases liquidity, reduces the risk and profitability. The reason is the opportunity cost of earning from excess investment in current assets is lost.

On the other hand, less investment in current assets reduces liquidity, but increases the risk and profitability. Thus, the amount of investment made in current assets has a bearing on liquidity and profitability. In fact, liquidity and profitability are inversely related. When one increases, the other decreases.

Therefore, the finance manager has to frame a suitable working capital management policy to strike a balance between the liquidity and profitability.

Working capital management policies also have a great impact on the structural health of the organization. If different components of working capital are not balanced, then in spite of the fact that current ratio and liquid ratio may indicate satisfactory financial position in respect of the liquidity of the firm, it may not in fact be as liquid as indicated by the current and liquid ratios.

For example, if the proportion of inventory is very high in the total current assets or greater proportion is appropriated by slow moving or obsolete inventory, then this cannot provide the cushion of liquidity.

Similarly, high investment in accounts receivables and failure to collect them on time will also adversely affect the real liquidity of the firm, thereby adversely affecting the structural health of the organization. In case, a firm maintains more cash and bank balances, it means that the firm is not making profitable use of its resources.

It is, therefore important that the finance manager has to frame proper working capital management policies for the various constituents of working capital i.e., cash, accounts receivables, inventories etc., so as to ensure higher profitability, proper liquidity and sound structural health of the organization. 

An adequate amount of Working Capital in the business is indispensable. Taking into account the business requirements, the amount of Working Capital should neither be more nor is less than what is required. 

Both the situations may be dangerous for the business. But along with the determination of the amount of Working Capital, we have to consider what should be the optimum level of investments in different current assets and for that level of investments what should be the optimum mix of short-term liabilities and long-term liabilities.

In other words, we have to decide what should be the level of amount of current assets and current liabilities (because this will decide the level of amount of Working Capital). This involves basic decisions relating to liquidity of the company and payments of current debts. 

To put it differently, we have to see what the need of liquidity to the concern is and when and at what interval current liabilities are to be paid.

Whatever the current assets the company has, to what extent and at what rate these assets can be converted into cash. This will depend on how cash and marketable securities are managed; what is the credit policy and procedure of the concern, how is inventory being managed and controlled and how are fixed assets managed?

If the concern is effectively managing the fixed assets, inventory is regularly controlled and credit policy and procedures are scientific, it can be said that lower the ratio of quick assets to total assets, higher will be the rate of return on total investments.

On the other hand, the cost of financing through current liabilities is less than the cost of financing through long-term funds. As such from the profitability point of view, the proportion/share of current liabilities in total liabilities should be higher. Not only this, more profit can be earned by using a short-term fund because it can be repaid when business does not need such funds.

On the basis of profitability assumption, it is clear that the proportion of current assets in total assets should be lower and share of current liabilities in total liabilities should be higher. However, the amount of Working Capital would be not only low but may be negative also, if the above principle is followed.

In other words, if this principle is followed, there may arise risk to the business concern. This risk is in terms of technical insolvency. In legal terms insolvency arises when assets are less than liabilities. In technical sense, insolvency means a situation when a concern is unable to meet its current obligations. Risk can be evaluated only when we analyse the liquidity position of the concern.

Liquidity signifies the ability of the concern to convert assets quickly in cash. Thus, if we want to keep the proportion of current assets at a low point, it becomes essential to have more liquidity in such assets; only then we can save the loss of risk. In fact, an integrated approach is needed on all these aspects while determining the volume of Working Capital. 


What is Working Capital Management – Meaning 

Working capital management refers to the management of current assets and current liabilities. Working capital management is a managerial strategy of maintaining efficient levels of components of working capital current assets & current liabilities. The term current assets refer to those assets, which in the ordinary course of business, turns in to cash.

The major component of current assets is cash, bills receivable, debtors and inventory. Current liabilities are those liabilities, which are paid, in the ordinary course of business. The basic current liabilities are bills payable, bank overdraft, and outstanding expenses.

Working capital management is concerned with maintaining an adequate amount of working capital, which is neither excessive or inadequate. Both excess and inadequate working capitals are not good for proper functioning of any business concern. Both excess and inadequate working capitals are dangerous to business. Therefore, a business concern should maintain an adequate amount of working capital.


Top 4 Objectives of Working Capital Management 

The objectives of working capital management could be stated as: 

1. To ensure optimum investment in current assets. 

2. To strike a balance between the twin objectives of liquidity and profitability in the use of funds. 

3. To ensure adequate flow of funds for current operations. 

4. To speed up the flow of funds or to minimise the stagnation of funds.


Concept of Working Capital Management 

The process of controlling the flow of working capital in the organization is known as working capital management. Working capital can be defined as gross working capital or net working capital. Gross working capital refers to the current assets of an organization. 

Current assets are those assets that can be converted into cash within one year or less than one year. There are various types of current assets, such as bills receivables, stocks, sundry debtors, and cash in hand and at the bank.

Net working capital can be defined as a difference between current assets and current liabilities. Current liabilities are those liabilities that are to be paid within one year or less than one year. Various types of current liabilities are sundry creditors, bills payables, bank overdrafts, salaries, and outstanding expenses. 

The timely payment of current liabilities out of current assets increases the goodwill of an organization. Different organizations need different types of working capital at different points of time. 

Working capital means the amount of funds required by an enterprise to finance its day-to-day operations. It is that part of the total capital which is employed in short term assets such as raw materials, account receivable inventory etc.

Working capital is required to bridge the time gap between production of goods and receipt of cash through sales. This time gap is called the operating cycle of the business. During the operating cycle, working capital keeps on circulating or revolving from one form to another. Working capital is also known as ‘circulating capital’ or rending capital. 

This is one of the methods to estimate working capital requirements. This method is called as operating cycle method.


Need for Working Capital Management  

The need for working capital arises out of four factors – 

(a) Sales volume, 

(b) Seasonal and cycli­cal factors, 

(c) Changes in technology, and 

(d) poli­cies of the firm.

The size and components of working capital are very much determined by the sales volume of the firm. Current assets are needed for supporting the operational activities culminating in sales. The manufacturing units usually maintain a ratio of 20 and 40 percent (current assets/sales). In different situations, however, the levels of working capital may be different.

With a steady level of sales, a fairly constant level of cash, receivables and in­ventory is the usual pattern of working capital management; while a firm with growing sales needs additional working capital and in case of declining sales, a reduction in permanent working capital is the prudent way of management.

Seasonal and cyclical factors affect the level of working capital. In a recession, a firm faces declin­ing sales and the need for inventories and the lev­el of receivables declines. While the market is characterised by high interest rates, customers pay their bills slowly and it causes an increase in receivables.

Technological developments are no less signifi­cant in the management of working capital. When the production process changes, it may affect the need for and the pattern of purchase of raw materials which in its turn affects the volume of working capital.

The policies of a firm definitely have an impact on the working capital management. A change in the policy affects the levels of permanent and variable working capital. For instance, if a firm changes its credit policy from net 40 to net 70, ad­ditional funds may be permanently tied up in re­ceivables.

So also, changes in production policy and safety level of cash on hand, permanent work­ing capital may increase or decrease. If the level of cash is linked to the level of sales, variable working capital may be affected.

It must be observed that working capital manage­ment must centre round sound cash planning since it is the very sensitive component of working capital.

Working capital is generally classified into Net Working Capital and Gross Working Capital.

Net Working Capital means current assets mi­nus current liabilities.

Gross Working Capital represents total current assets only and it is a concept very popular in fi­nancial management circles, though it cannot re­veal the true financial position of a company which the net working capital can. The gross con­cept of capital is popular with companies because of separation of ownership from management. Managers are not usually interested in the owner­ship of current or fixed assets.

Working Capital Management is to ensure max­imum productivity and profits in the employment of capital. To maintain a smooth and rapid flow of funds is of compelling necessity to enhance the ef­ficiency of working capital or profitability of the company. 

In the management of working capital, it becomes a sound principle to see that sufficient cash reserve is maintained to meet all normal as well as abnormal cash needs. Cash receipts and cash outlay do never synchronise, so there is the need for maintaining cash reserves.

The amount of working capital needed, to keep the organisation in sound financial health, to maintain regular and uninterrupted cash flow, must be ascertained. A number of factors determine the amount of working capital. 

They are – gene­ral type of business, size of the business, terms of purchase and sales, turnover of inventories, process of manufacture, seasonal variations, banking con­nections, dividend policy etc. The growth and ex­pansion of the organisation should also deserve consideration while managing working capital.

Working capital management, as we have dis­cussed above, involves deciding upon the amount and composition of current assets and how to fi­nance these assets. These decisions involve trade­offs between risk and profitability. It is a matter for the financial management to take note that the greater the relative proportion of liquid as­sets, the less the risk of running out of cash, all other things being equal; of course, the profitabili­ty will be less.

The risk of cash insolvency is less when the composite maturity of schedule of securi­ties is longer, other things being equal, and again, the profits of the company are likely to be less.

We have so far talked about working capital man­agement in a broad sense assuming the efficient management of the various components of current assets.

Now, let us see how to improve the efficiency of cash management and how to invest excess funds in marketable securities. The working capital mana­gement needs to determine how much will be car­ried in cash out of the overall level of liquid as­sets and how much will be carried in marketable securities.

Cash is held for three motives – the transaction motive, the prevention motive and the speculative motive. All these motives are quite distinct – one is for payments in the ordinary course of business; one for meeting contingencies and the third one relates to holding cash to take ad­vantage of expected changes in security prices.

The object of cash management as a part of working capital management is to attain maxi­mum cash availability and maximum interest in­flow on any idle funds. This necessitates accelera­tion of collections and slowing up of disbursements.

Collections can be accelerated by various means and disbursements should be handled to give max­imum transfer flexibility and the optimum timing of payments.

Capital management, in the broad sense, consti­tutes the main objective of financial management. Fixed and working capital, with their constitu­ents, have to be dealt with utmost care to ensure a sound capital structure of a firm.

Working capital management, after considera­tion of several factors, leads us to comment that it is the important component of the capital structure that needs a very judicious and careful handling to have a regular cash flow to meet normal as well as abnormal situations. The effective operation and smooth going-on of a firm is more the effect of product management of working capital, which no one can dispute.

“The operation of a business enterprise involves the conversion of cash into non-cash assets which, when used, are converted back in cash form. The funds used in this circuit flow can be raised in a number of ways. The selection of means to raise funds together with the associated uses has a strong bearing on the soundness of financial pro­gramme of a business firm.” (S.C. Kuchhal).

The funds flow statement, in the condensed re­port form, shows how the activities of the business have been financed and how the financial resourc­es have been used. So, this is important for fi­nancial management to ensure sound working capital management. The funds flow statement may be prepared to analyse and study the position of net working capital.

Cash flow, though a misnomer (because it is nei­ther cash nor flow) is a useful concept used as one of the tools of investment analysis. A related con­cept is that of net cash flow which means ‘after-­tax earnings’ retained by the firm or, conversely, gross cash flow minus depreciation. It may be observed that when revenue is realised concurrently with cash receipts and expenses are recorded at time of disbursements, we have coincident flows.

A proforma or projected source and uses of funds statement can be constructed to show the acquisi­tion and employment of funds by a firm during some future period.

In this connection, depreciation can be properly included in a measure of the amount of cash flow. Though depreciation is principally an allocation of cost to operation, its financial aspect is also sig­nificant.

The funds flow statement is helpful in visualizing the movement of funds that constantly take place. A build-up of working capital can be decep­tive if it is obtained by reducing other liquid as­sets. The funds flow statement helps in detecting the sources for financing the heavy accumulation of inventory and accounts receivables.

In the management of working capital, the funds flow statements render services in more than one way. It helps in forecasting the flow of funds. It provides an insight into the financial opera­tions of a firm. It also helps in the evaluation of the firm’s financing – what portion of the firm’s growth was financed internally and what portion externally. We can judge through the statement whether the firm has expanded too fast and whether financing is strained.

Working capital management is important, complex and a number of problems associated with this management give it a separate entity. Work­ing capital is one of the conditioning factors in the long run operations of a firm. Working capital calls for financial manoeuvering; this is to ensure effective use of funds for minimising the risk of loss to attend proper objectives.

Both internal and external financing come within the purview of the financial management. Internal financing determines the size of working capital needs in particular business situations and seeks to achieve certain long-run operating goals.

The concepts of working capital to the management are gross and net working capitals. Gross working capital is concerned with the management of individual current assets in the day-to-day op­eration, while net working capital helps the man­agement to look for permanent sources for its fi­nancing, since management is more concerned with the total current assets which constitute total fun­ds available for operating periods than with the source from where the funds come.

To say precisely, management gives attention to the total amount of current assets and their profit earning capacity so that it is higher than the cost of borrowing.

The net working capital concept does not have much relevance in the corporate form of business organisation since, in this form, there is no close contact between ownership of capital and its ma­nagement.

In measuring working capital balance, the fi­nancial data of the balance sheet is used. Working capital balance indicates something positive but inefficient uses of working capital may exceed the sources of working capital in a particular period which may, however, be offset by efficient man­agement in the following period.

The financial manager should study the causes of changes in the balances and should take appropriate steps to cor­rect the position. This involves the basic ap­proach to working capital analysis. Besides meas­uring changes in the balances of working capital in terms of rupees, we can do so in terms of percentag­es by a comparative study of current assets, current liabilities and working capital over a number of years.

Various devices can be used by the management to ascertain whether working capital is being properly managed. Ratio analysis enables the management to check upon the efficiency with which working capital is being employed.

In its two forms – behaviour of ratios over a certain period and comparison of ratios between similar concerns – ratio analysis may be the study of turn­over of working capital over a definite period; it may be current ratio analysis or it may be current debt to tangible net worth analysis. These differ­ent ratio analyses reveal different facts to the management.

The turnover of net working capital ratio measures the rate of working capital utilisa­tion whereas the current ratio measures the rela­tive ability of a company to pay its short term debts and current liabilities to tangible net worth ratio shows how much capital has come from short-term creditors and how much from the own­ers.

The working capital budget is also an important tool for the management of working capital. It measures permanent and variable working capital requirements and thus the management can be rest assured that the variable working capital re­quirements are duly provided for.

Working capi­tal may be fixed or variable and in arranging the finance for an enterprise, this distinction of work­ing capital between regular and variable is impor­tant. Regular working capital is provided on a long term basis by ploughing back of profits and by the issue of shares and debentures.

Variable work­ing capital is meant for meeting temporary needs of a company and this is raised from internal oper­ation as well as from various credit supplying agencies. Some companies, of course, prefer to raise such capital from retained earnings or from the sale or shares of long term debt. Part of vari­able working capital may be obtained from trade creditors.

Working capital requirement, in general, may be reduced by favourable credit terms to customers.

Working capital requirements for a short period are now being met by bank loan against hypothe­cation or pledge of inventory or mortgage of fixed assets.


Aspects of Working Capital Management – Components of working Capital, Management Aspects, Monetary Aspects and More…

There are various aspects related to this function:

i. Components of working capital.

ii. Management aspects

iii. Monetary aspects

iv. Monetary tools

v. Management action and review.

Monitoring and management aspects

i. working capital under its different components must be within the normal limits as prescribed by the management and as per normal practices as well as banking norms who have financed the working capital. 

Banks will finance only for the supplementary requirement, i.e., companies should approach the banks only for the shortfall. Banks will finance for the net amount of working capital adjusted by the initial funding, i.e., 25% of short fall financed from long-term funds.

ii. Whenever there are deviations, reasons must be looked into and corrective action taken immediately.

iii. Regular review.

iv. Reports for each component to be prepared and submitted to the concerned authorities and agencies as per periodicity decided. Report should be given to the Chief of Materials Management and Chief of Finance.

v. Ratio analysis as a tool for monitoring the various components.

Inventories

i. Inventories under all the categories of materials, i.e., raw materials, stores and spares.. stock-in-process and finished goods should never be allowed to be excess as well as in the stock-out situation.

ii. Inventories carry cost. Therefore, there should always be a smooth relationship amongst the orderings, procurements, consumption and stocks at the end for all the components of inventories. Carrying cost of inventories will be interest on money blocked in inventory, stores handling, insurance charges, damages of materials, ground rent, warehouse expenses and other overheads, etc.

Monitoring parameters for all the materials under inventories should be pre-decided.

These may be broadly as under:

1. Level of inventories of raw materials, stores and spares should be sufficient to meet the requirements of production and should never create a stock out situation.

2. There should be balance amongst the:

i. Lead time for procurements

ii. Ordering position, i.e., supplies ordered, but yet to be received.

iii. Present inventory position

iv. Consumption rate per month.

Sundry debtors

i. There should be no outstanding sundry debtors beyond the credit period.

All delayed outstanding realisations from the customers should be reported and reviewed periodically.

Advances

i. Advances to the employees must be recovered. And all the other advances for the supplies must be adjusted with the payments to be made to the suppliers. Thus, no advance should remain outstanding after the supplies are over from the suppliers.

Sundry creditors

i. Full credit period must be availed from all the suppliers.

ii. Advance payments should not be encouraged in normal conditions.

iii. Similarly, payment against letter of credit (LC) should be discouraged, as far as possible.

 Thus, these are the broad areas of monitoring in the management of working capital.    


Factors Affecting Working Capital Requirements – Nature of Business, Scale of Operations, Production Policies, Credit Policy, Dividend Policy and More…

Number of factors affects/leads to change in the quantum of working capital requirements of a concern.

The various such factors, which affect the working capital requirements of a concern, are:

1. Nature of Business

2. Scale of operations

3. Length of the operating cycle

4. Growth and expansion of business

5. Length of manufacturing process

6. Production policies

7. Rapidity of turnover

8. Seasonal fluctuation in demand

9. Reliability of supply

10. Operating efficiency

11. Credit Policy

12. Credit facilities enjoyed by the Creditors

13. Nature of Competition in the Market

14. Dividend Policy

A brief explanation of each of the above factor is given below:

1. Nature of Business:

The nature of business is one of the important factors determining the working capital requirements of a concern. Service rendering and public utility concerns business or industries like Railways, electricity supply companies require small amounts of working capital. However, manufacturing and trading concerns like the steel industry, cement industry require large sums of working capital.

2. Scale of Operations:

Size of operations is also an important factor affecting the working capital requirements. Large-size business organizations require large amounts of working capital. Small size business organizations require a small amount of working capital.

3. Length of the Operating Cycle:

The length of the operating cycle influences the size of working capital. Longer the length of the operating cycle greater is the amount working capital. For example in the case of the shipbuilding industry, aircraft-manufacturing industries require more working capital. Shorter the length of the operating cycle smaller is the amount working capital.

4. Growth and Expansion of Business:

Growth and expansion of business also affects working capital requirements of a concern. The growing & expanding business firms require relatively more amount of working capital compared to the firms, which are not growing and expanding.

5. Length of Manufacturing Process:

Length of manufacturing process also influences the amount of working capital. Longer the manufacturing process, the higher will be the amount of working capital. In trading concern, no manufacturing process is involved so a small amount of working capital is required.

6. Production Policies:

Production policies are one of the factors affecting working capital requirements. For example, capital-intensive industries require more fixed capital and small amounts of working capital. The labour intensive industries require more working capital.

7. Rapidity of Turnover:

The rapidity of turnover of inventories has influence on working capital requirements of a business concern. If goods are sold quickly, it requires less working capital. On the other hand, if turnover is very low a concern requires more working capital. For example consumer goods industries require less working capital because of high rates of turnover. However, Jewelers industries require more working capital because of low rate of turnover.

8. Seasonal Fluctuation in Demand:

Seasonal fluctuation in demand also influences the amount of working capital. If the demand is fluctuating, then the amount of working required also varies. Cyclical factors also affect working capital. During the boom period, concern requires more working capital. During the recessionary period, a concern requires less working capital.

If the demand is stable, less amount of working capital is required. On the other hand, demand is highly fluctuating as in the case of readymade dresses a larger amount of working capital is required.

9. Reliability of Supply:

The nature of supply of raw material decides the size of working capital. If there is variation in supply of raw materials, source of supply is not reliable, supply is irregular then large amounts of working capital are required to maintain more quantity of inventories. On other hand, if supply is constant, regular and reliable small amounts of working capital is enough.

10. Operating Efficiency:

The operating efficiency of a firm affects its working capital requirements. High efficient companies use its resources efficiently and require less working capital. On the other hand, a firm, which does not enjoy operating efficiency, needs more working capital.

11. Credit Policy:

The credit policy of a firm determines its size of working capital requirements. When the firm follows liberal credit policy and sells goods and services on credit, it requires more working capital. On the other hand, if the firm follows stricter credit policy, then the firm requires a relatively small amount of working capital.

12. Credit Facilities Enjoyed from Creditors:

The credit facilities enjoyed from creditors will affect its size of working capital. A firm which enjoys liberal credit facilities from its suppliers needs lesser working capital than a firm, which does not enjoy liberal credit facilities from its suppliers.

13. Nature of Competition in the Market:

Competitive conditions prevailing in the market influences the size of working capital of a business concern. The firm facing stiff competition in the market has to provide liberal credit facilities to their customers to retain them and to face the competition. 

In addition, they require keeping large quantities of inventories to meet customer’s orders in time. For these reasons, the firm requires a large amount of working capital. On the other hand, a monopoly firm needs a small amount of working capital.

14. Dividend Policy:

Dividend policy also affects working capital requirements of a firm. A firm following liberal cash dividend policy requires more working capital. On the other hand, a firm following strict dividend policy requires a small amount of working capital.


Importance of Working Capital Management 

Working capital management involves the management of the current assets and the current liabilities of a firm. A firm’s value cannot be maximized in the long-run unless it survives in the short-run.

The importance of working capital management has been summed up in the following paragraphs:

(a) A substantial portion of total capital funds is invested in current assets. In periods of rising capital costs and scarce funds, the working capital is one of the most important areas requiring management review.

(b) A firm can exist and survive without making a profit, but cannot survive without working capital funds. If a firm is not earning profit it may be termed as ‘sick’, but, not having working capital can result and lead to legal troubles, liquidation of assets and potential bankruptcy. Thus, each firm must decide how to balance the amount of working capital it holds, against the risk of failure.

(c) Sales expansion, dividend declaration, plants expansion, new product line, increase in salaries and wages, rising price level, etc., put additional strain on working capital maintenance. It becomes necessary to know when to look for working capital funds, how to use them and how to measure, plan and control them.

(d) An adequate amount of working capital is very essential for smooth running of an enterprise. An efficient management of working capital funds helps in utilizing fixed assets gainfully and helps the firm to achieve the overall goal of maximization of the shareholders’ wealth. 

For instance, shortage or bad management of cash may result in loss of cash discount and loss of reputation due to non-payment of financial obligations on due dates. Insufficient inventories may be the main cause of production disruptions and it may compel the enterprises to purchase raw materials at unfavourable rates.

Thus, sound working capital management is very important for a firm’s survival. Working capital has acquired a great significance in the recent past as an enterprise needs to balance the twin objectives of profitability and liquidity.


Requirement for Maintaining an Adequate Amount of Working Capital 

The requirement for maintaining an adequate amount of working capital has been stated below:

1. Smooth supply of raw materials

Raw material is essential for production and an adequate amount of Working Capital ensures sufficient amounts of funds to carry day-to-day operations and hence raw materials supply can be ensured on a regular basis.

2. Benefit during purchase

Optimum amount of Working Capital ensures sufficient amounts of cash to meet the daily expense. If raw materials can be purchased in bulk and most importantly in cash then facilities of cash discount can be obtained.

3. Continuity in production

The optimum amount of Working Capital ensures continuity in production without any interruption due to fund crisis.

4. Regularity in wage payment

Sufficient amount of Working Capital ensures regularity in payment of wages to employees which also prevent any sort of discontent among employees.

5. Regularity in payment of other expenses

Overhead cost is also another important element of cost of production. Ample amount of Working Capital ensures regularity in payment of overhead expenses other than materials and labour.

6. Creating goodwill

Adequate Working Capital assures timely payment of debt and all expenses, which helps in creating goodwill in the market.

7. Solvency

Repaying short-term obligations at the right time indicates a good solvency position of the business.

8. Easy availability of loan

Adequate Working Capital facilitates easy availability of loans from banks and other financial institutions since sufficient Working Capital indicates a solvent position of the business with a good debt-repaying capacity.

9. Helps to tide over the situation of crisis

Adequate or sufficient amount of Working Capital helps to tide over the situation of crisis if it arises during the recession period of an economy. Strong and healthy Working Capital base ensures availability of funds for meeting day-to-day expenses.

10. Ensuring assured Return on Investment

Adequate Working Capital ensures smooth availability of day-to-day funds. Sufficient Working Capital helps to procure raw ma­terials easily and helps to make payments easily thereby making the production process smooth. Fast rotation of Working Capital ensures higher profit and less inventory level, which thereby ensures higher payment of dividend to shareholders and interest to fund providers.

11. Gaining confidence of third parties and creditors

Smooth and strong Working Capital base assists in gaining the confidence of third parties and creditors by making their payments timely.

12. Optimum utilisation of fixed assets

Sufficient Working Capital ensures optimum utilisation of fixed assets. Fixed assets should be utilised optimally, i.e., to obtain higher return at a minimum cost. Strong Working Capital base ensures optimum utilisation of fixed assets thereby helping to absorb the other charges relating to the fixed assets.

13. Increase in efficiency

Adequate Working Capital helps to make payments at the right time, facilitates the purchase of raw materials, meeting expenses at the right time, thereby ensuring smooth production which in turn helps to increase the morale of employees and hence the overall efficiency of the business.

Working Capital indeed has a significant role in maintaining a smooth and uninterrupted flow of production. The importance of Working Capital cannot be ignored by a business; hence every business should try to ensure that a strong base of Working Capital is maintained.


Types of Working Capital – Temporary, Permanent, Seasonal and Special Working Capital

Let us discuss the types of working capital in brief:

Type # 1. Temporary Working Capital:

Refers to the working capital that is required to produce extra units of products in case of excess demand. However, it is not necessary that demand for the product would always be high in the market. Therefore, when the demand of the product increases, extra working capital is raised from short-term sources. The temporary working capital is also known as fluctuating working capital.

Type # 2. Permanent Working Capital:

Refers to the working capital that is needed for the smooth running of the business. The permanent working capital is required on a daily basis for production and payment of current liabilities. If an organization fails to maintain permanent capital, it will cease to exist in the long run.

Type # 3. Seasonal Working Capital:

Refers to the capital required by organizations in seasonal industries. Seasonal industries are those industries that operate in a specific season and shut down their activities by the end of the season. Examples of seasonal industries are the umbrella and raincoat industries.

Type # 4. Special Working Capital:

Refers to the capital requirement of different sectors, such as primary, secondary, and tertiary, of an economy. The working capital requirement of the primary sector is seasonal in nature. The secondary sector requires huge working capital for maintaining stock and paying salaries. The tertiary sector requires less working capital as compared to the secondary sector as it renders services to conduct its business on a cash basis.


Classification of Working Capital

Generally speaking the amount of funds required for operating needs varies from time to time in every business. But a certain amount of assets in the form of working capital are always required, if a business has carried out its functions efficiently and without break. 

These two types of requirements permanent, and variable are the basis for a convenient classification of working capital as follows: 

Permanent or fixed working capital:

As is apparent from the objective “Permanent” it is the part of the capital which is permanently locked up in the circulation of current assets and in keeping it moving.

For example every manufacturing concern has to maintain stock of raw materials, work in progress finished products, loose tools and equipments. It also requires money for the payment of wages and salaries throughout the year.

The permanent or fixed working capital can again be subdivided into-

1) Regular working capital and

2) Reserve margin or cushion working capital.

i) Regular working capital:

Is the minimum amount of liquid capital needed to keep up to the circulation of the capital from cash to inventories, to receivable and again to cash. This would include sufficient minimum bank balance to discount all bills, maintain adequate supply for raw materials for processing, carry sufficient stock of goods to give prompt delivery etc.

ii) Special working capital:

Special working capital is that part of the variable working capital which is required for financing the special operations, such as extensive marketing campaigns, experiments with products or method of production carrying of special job etc.

The distinction between fixed and variable working capital is of great significance, particularly in raising the funds for an enterprise. Fixed working capital should be raised in the same way as fixed capital is procured. Variable needs can, however be financed out of short term borrowing from the bank or from the public.

The following diagrams illustrate the difference between permanent and temporary working capital: 

Fig 11.4: The permanent working capital is increasing over a period of time with increase in the level of business activity. This happens in case of growing companies. Hence the permanent working capital line is not horizontal with the baseline as in fig 11.3.


Kinds of Working Capital (On the Basis of Time Investment)

Operating cycle is repeated again and again and results in a continuous requirement of working capital. Every time, a certain amount of money will always remain invested in current assets. However, the requirement of working capital may fluctuate from time to time on the basis of several factors.

On the basis of time of its investment, working capital can be divided into two categories:

1. Permanent working capital

2. Temporary working capital.

Kind # 1. Permanent Working Capital:

This is the minimum level of working capital required at all times to carry out an average level of business activities. In other words, a certain minimum amount of investment in current assets is required on a continuous and uninterrupted basis. This investment is referred to as permanent or fixed working capital.

As we now know that permanent working capital is required all the time in business, hence it should be financed through long-term funds. Permanent working capital requirement may change with the passage of time due to increase in the level of business activities (i.e. Production, sales etc.)

Kind # 2. Temporary Working Capital:

The amount of working capital needed may keep on fluctuating from time to time on a temporary basis because of seasonal changes in production and sales activities of a business. This temporary increase in working capital for a short duration of time is known as temporary or fluctuating working capital.

In other words, working capital needed over and above the permanent level of working capital at a particular point of time is called temporary or fluctuating working capital. Temporary and permanent working capital can be illustrated as shown in Fig. 11.2 below –

When there is an increase in permanent working capital due to the increased level of business activity at different points of time, it can be illustrated as shown in Fig. 11.3 below –


Working Capital Management – 6 Broad Principles 

The following are the broad principles of working capital management:

1) Requisite amount of working capital should be raised at minimum cost.

2) Excess of debts and receivables should be avoided.

3) Excessive establishment expenses should be eliminated.

4) Necessary inventories should be purchased at competitive rates.

5) Suitable credit collection policy should be followed to minimize the problem of collections.

6) Economy in the use of inventories and quick turnover of finished goods should be planned.


4 Main Principles of Working Capital Management 

Principles of working capital management are as follows:

(i) Principle of Risk Variation:

Risk here refers to the inability of a firm to maintain sufficient current assets to pay for its obligations. If working capital is varied relative to sales, the amount of risk that a firm assumes is also varied, and the opportunity for gain or loss is increased. In other words, there is a definite relationship between the degree of risk and the rate of return. As a firm assumes more risk, the opportunity for gain or loss increases.

As the level of working capital relative to sales decreases, the degree of risk increases. When the degree of risk increases, the opportunity for gain and loss also increases. Thus, if the level of working capital goes up, the amount of risk goes down, the opportunity for gain or loss is likewise adversely affected.

Depending upon their attitudes, the management changes the size of their working capital. A conservative management prefers to minimise risks by holding a higher level of working capital, while liberal managements assume greater risk by reducing this level. 

The goal of a management should, however, be that level of working capital which would optimise a firm’s rate of return. This level is the point at which the incremental loss associated with the decrease in working capital investment becomes greater than the incremental gain associated with that investment.

(ii) Principle of Cost of Capital:

This principle emphasises the different sources of finance, for each source has a different cost of capital. It should be remembered that the cost of capital moves inversely with risk. Thus, additional risk capital results in the decline in the cost of capital.

(iii) Principle of Equity Position:

According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the working capital should contribute to the new worth of the firm.

(iv) Principle of Maturity of Payment:

A company should make every effort to relate maturities of payment to its flow of internally generated funds. There should be the least disparity between the maturities of a firm’s short-term debt instruments and its flow of internally generated funds because a greater risk is generated with greater disparity. A margin of safety should, however, be provided for short-term debt payments.


Steps Involved in Working Capital Management – Preparing the Sales Budget, Preparing the Inventory Budget, Material and Labour Budget and More…

Management must take the following steps to ensure balanced proportion of capital consistent with the object of liquidity and profitability:

1) Preparing the Sales Budget

Management should prepare sales budgets to estimate the volume and value of expected sales and the amount of cash likely to be realized on sales during the budget period, with reference to the average credit terms granted and the incidence of direct cash sales.

2) Preparing the Inventory Budget, Material and Labour Budget

Inventory budget is to be prepared indicating the potential increase and decrease in the stock of goods to be held during the budget period. The raw materials budget shows the estimated volume and produces the budgeted targets of output. Labour budget shows the direct cost of labour essential to carry out the production programme.

3) Advertising and Selling Expenses Budget

This budget gives an idea of expenses to be incurred to fulfill the sales targets.

4) Preparing General Expense Budget

This budget indicates all administrative costs of several departments.

5) Cash Budget

Management should prepare a cash budget. It is an important tool of working capital management. “It is an estimate of future receipt and disbursements of cash and the future level of cash account of each month, week or other division of time”.

It shows the following:

a) Estimates of cash, expected to be received during the period from sales and other sources.

b) Estimated payments of cash on various counts purchases, payments of salary etc., and general expenses including taxes, dividends etc.

c) Estimated cash balance at the end of the period, and

d) The difference between estimated cash balance and the cash that may be actually required as per different budget estimates. Cash budget predicts, whether additional cash should be raised to plug the gaps between the expected inflow and expected outflow. It indicates when the amount borrowed can be repaid out of expected cash receipts.

6) Working Capital Budget

On the basis of above mentioned operating budgets, working capital budget is prepared to secure maximum productive use of current assets. Working capital budget set forth the estimated normal and seasonal current capital needs of the business and the plans to meet them as they arise.

 “It provides a broad picture of future requirements and to make the most satisfactory arrangements for meeting those ends”. It enables the management to make prior arrangements for purchases and to plan production and sales with further utilization of resources.


Approaches to Working Capital Estimation – Total Cost and Cash Cost Approach

In estimation of working capital two approaches are in practice:

(a) Total Cost Approach and

(b) Cash Cost Approach.

(a) Total Cost Approach:

According to this approach, all costs including depreciation and profit margin are included while estimation of working capital. Unless it is specifically mentioned, the estimation of working capital under total cost approach is suggested.

(b) Cash Cost Approach:

According to this approach, estimation of working capital is done on the basis of cash costs. Depreciation is excluded from total cost of production or cost of sales. The profit margin is also excluded in computation of debtors balance. 


Dimensions of Working Capital Management – Inventory, Cash and Receivables Management

Working capital management is usually concerned with the management of all the current assets and current liabilities. It involves – determining the need for working capital and estimating the optimal level of investment in current assets. In working capital management, we have to strike a balance between risk and profitability without affecting structural health of the firm.

If the amount of working capital is high, liquidity is high. But current assets are not earning assets of the company and hence the profitability will also be low. Similarly, if the amount of working capital is less, a high turnover ratio indicates higher profitability. But liquidity may be seriously affected, causing loss of reputation in the short run.

The various dimensions of working capital management are as follows:

1. Inventory Management:

Inventory management is concerned with the control and management of various inventories such as raw ma­terial, work in progress and finished goods. It refers to maintaining the optimum amount of investment in inventories (stock). If the stock level is too low, it can lead to a stoppage in the production process and excessive investment in stocks increases the opportunity cost.

Thus, an optimum level has to be maintained as both the situations are not good for efficient running of a company. Various techniques are also used for inventory management like Economic Order Quantity (EOQ), fixing stock levels, ABC technique, Just in Time (JIT) approach, etc.

2. Cash Management:

It refers to maintaining the optimum level of cash in a company. It includes managing currency, cheques, drafts, bank deposits and near cash assets such as marketable securities and time deposits in banks as they can be converted into cash at any time. 

On one hand, too low cash can lead to disruptions in making timely payments and on the other hand, it is also important to use excess cash in some profitable way. It is the most important area of working capital management as cash is the basic component of all the current assets.

3. Receivables Management:

Receivables or debtors arise when goods are sold on credit. On one hand, providing credit facility boosts the sales by attracting customers and thus increases profitability but on the other hand, chances of bad debts also increase with increasing debt which leads to high risk.

Thus, receivables management is im­portant to maintain an optimum balance of debtors which   increases profitability at acceptable levels of risks. Various ways can be used to reduce the risk of bad debts by adopting strict credit policies, following strict collection procedures, etc.


Control over Working Capital 

The commercial banks play a very significant role in financing working capital needs. These work­ing capital needs have been met mainly in the form of cash credit facilities and these advances have been totally security oriented rather than end-use oriented.

As such, the big units which were able to provide securities to the banks were able to get the main chunk of the finances provided by the banks whereas others experienced shortage of inputs, lower capacity utilisation, high cost of production and ultimately threat of closure. 

Reserve Bank of India has attempted to identify major weaknesses in the system of financing of working capital needs by Banks in order to control the same properly.

These attempts were mainly in three forms:

(a) Dahejia Committee.

(b) Tandon Committee.

(c) Chhore Committee.

(a) Dahejia Committee:

This committee was appointed in October 1968 to examine the extent to which credit needs of industry and trade are likely to be inflated and how such trends could be checked.

Findings:

The committee found out that there was a tendency of in­dustry to avail of short term credit from Banks in excess of growth rate in production for inventories in value terms. Secondly, it found out that there was a diversion of short term bank credit for the acquisition of long term assets.

The reason for this is that generally banks granted working capital finance in the form of cash credit as it was easy to operate. Banks took into consideration security offered by the client rather than assessing financial position of the borrowers. As such, cash credit facilities granted by the banks were not utilised necessarily for short term purposes.

Recommendations:

The committee firstly recommended that the Banks should not only be security oriented, but they should take into consideration the total financial position of the client Secondly, it recommended that all cash credit accounts with banks should be bifurcated in two categories.

(i) Hard core which would represent the minimum level of raw materi­als, finished goods and stores which any industrial concern is required to hold for maintaining certain level of production and

(ii) Short term components would represent funds for temporary pur­poses i.e., short term increase in inventories, tax, dividend and bonus pay­ments etc.

It also suggested that hard core parts in case of financially sound companies should be put on a term loan basis subject to repayment schedule. In other cases, borrowers should be asked to arrange for long term funds to replace bank borrowings.

In practice, recommendations of the committee had only a marginal ef­fect on the pattern and form of banking.

(b) Tandon Committee:

In August 1975, Reserve Bank of India appointed a study group under the Chairmanship of Mr. P. L. Tandon, to make the study and recommen­dations on the following issues:

(i) Can the norms be evolved for current assets and for debt equity ra­tio to ensure minimum dependence on bank finance?

(ii) How the quantum of bank advances may be determined?

(iii) Can the present manner and style of lending be improved?

(iv) Can an adequate planning, assessment and information system be evolved to ensure a disciplined flow of credit to meet genuine production needs and its proper supervision?

The observations and recommendations made by the committee can be considered as below:

(1) Norms:

The committee suggested the norms for inventory and ac­counts receivables for as many as 15 industries excluding heavy engineering industry. These norms suggested represent maximum level of inventory and accounts receivables in each industry. However if the actual levels are less than the suggested norms, it should be continued.

The norms were suggested in the following forms:

i. For Raw Materials – Consumption in months.

ii. For Work in Progress – Cost of production in months.

iii. For Finished Goods – Cost of sales in months.

iv. For Receivables – Sales in months.

It was clarified that the norms suggested cannot be absolute or rigid and the deviations from the norms may be allowed under certain circum­stances.

Further, it suggested that the norms should be reviewed constantly.

It was suggested that the industrial borrowers having an aggregate limits of more than Rs. 10/- lakhs from the Banks should be subjected to these norms initially and latter it can be extended even to the small borrow­ers.

(2) Methods of Borrowings:

The committee recommended that the amount of bank credit should not be decided by the capacity of the borrower to offer security to the banks but it should be decided in such a way to supplement the borrower’s resources in carrying a reasonable level of cur­rent assets in relation to his production requirement.

For this purpose, it in­troduced the concept of working capital gap i.e. the excess of current assets over current liabilities other than bank borrowings. It further suggested three progressive methods to decide the maximum limits to which banks should provide the finance.

Method I:

Under this method, the committee suggested that the Banks should finance maximum to the extent of 75% of working capital gap, re­maining 25% should come from long term funds i.e. own funds and term borrowings.

Method II:

Under this method, the committee suggested that the bor­rower should finance 25% of current assets out of long term funds and the banks provide the remaining finance.

Method III:

Under this method, the committee introduced the concept of core current assets to indicate a permanent portion of current assets and sug­gested that the borrower should finance the entire amount of core current assets and 25% of the balance current assets out of long term funds and the banks may provide the remaining finance.

To explain these methods in further details, let us consider the following data:

The maximum amount of bank finance can be decided as below: 

It can be observed from above that the gradual implementation of these methods will reduce the dependence of borrowers on bank finance and im­prove their current ratio. The committee suggested that the borrowers should be gradually subjected to these methods of borrowings from first to third. However, if the borrower is already in the second or third method of lending, he should not be allowed to slip back to the first or second method of lending respectively.

It was further suggested that if the actual bank borrowings are more than the maximum permissible bank borrowings, the excess should be converted into a term loan to be amortized over a suitable period depending upon the cash generating capacity.

(3) Style of Lending:

The committee suggested changes in the manner of financing the borrower. It suggested that the cash credit limit should be bifurcated into two components i.e. minimum level of borrowing required throughout the year should be financed by way of a term loan and the demand cash credit to take care of fluctuating requirements.

It was suggested that both these limits should be reviewed annually and that the term loan component should bear slightly a lower rate of interest so that the borrower will be motivated to use the least amount of demand cash credit. The commit­tee also suggested that within overall eligibility, a part of the limits may be in the form of bill limits (to finance the receivables) rather than in the form of cash credit.

(4) Credit Information Systems:

In order to ensure the receipt of op­erational data from the borrowers to exercise control over their operations properly, the committee recommended the submission of quarterly reporting system, based on actuals as well as estimations, so that the requirements of working capital may be estimated on the basis of production needs.

As such, borrowers enjoying total credit limit aggregating Re. 1 Crore and above were required to submit certain statements in addition to monthly stock statements and projected balance sheet and profit and loss accounts at the end of the financial year. 

The working capital limits sanctioned will be reviewed on an an­nual basis. Within the overall permissible level of borrowing, the day to day operations will be regulated on the basis of drawing power.

(5) Follow up, Supervision and Control:

In order to assure that the assumptions made while estimating the working capital needs still hold good and that the funds are being utilised for the intended purpose only it was suggested that there should be a proper system of supervision and control. Variations between the projected figures and actuals may be permitted to the extent of 10%, but variations beyond that level will require prior ap­proval.

After the end of the year, credit analysis should be done in respect of new advances when the banks should re-examine terms and conditions and should make necessary changes. For the purpose of proper control, it suggested the system of borrower classification in each bank within credit rating scale.

(6) Norms for Capital Structure:

As regards the capital structure or debt equity ratio, the committee did not suggest any specific norms. It opined that debt equity relationship is a relative concept and depends on several fac­tors. Instead of suggesting any rigid norms for debt equity ratio, the com- m it Lee opined that if the trend of debt equity ratio is worse than the medi­ans, the banker should persuade the borrowers to strengthen the equity base as early as possible.

Action Taken by RBI:

According to the notification of RBI dated 21st August 1975, RBI ac­cepted some of the main recommendations of the committee.

(1) Norms for Inventories and Receivables:

Norms suggested by the committee were accepted and banks were instructed to apply them in case of existing and new borrowers. If the levels of inventories and receivables are found to be excessive than the suggested norms, the matters should be discussed with the borrower. If excessive levels continue without justification, after giving reasonable notice to the borrowers, banks may charge excess interest on that portion which is considered as excessive.

(2) Coverage:

Initially, all the industrial borrowers (including small scale industries) having aggregate banking limits of more than Rs. 10/- lakhs should be covered, but it should be extended to all borrowers progressively.

(3) Methods of Borrowing:

RBI instructed the banks ‘hat all the cov­ered borrowers should be placed in method I as recommended by the com­mittee. However, all those borrowers who are already complying with the require­ments of Method II should not slip back to method I. As far as Method III is concerned, RBI has not taken any view. However, in case of the bor­rowers already in method II, matter of application of Method III may be de­cided on case to case basis.

(4) Style of Credit:

As suggested by the committee, instead of grant­ing the entire facility by way of cash credit, banks may bifurcate the limit as (i) Term loan to take care of permanent requirement and (ii) Fluctuating cash credit. Within the overall limits, bill limits may also be considered.

(5) Information System:

Suggestions made by the committee regarding the information system were accepted by RBI and were made applicable to all the borrowers having the overall banking limits of more than Rs. 1 crore.

(c) Chhore Committee:

In April 1979, Reserve Bank of India appointed a study group under the chairmanship of Mr. K. B. Chhore to review mainly the system of cash credit and credit management policy by banks.

The observations and recommendations made by the committee can be discussed as below:

(1) The committee has recommended increasing the role of short term loans and bill finance and curbing the role of cash credit limits.

(2) The committee has suggested that the borrowers should be required to enhance their own contribution in working capital. As such, they should be placed in the Second Method of lending as suggested by the Tandon Committee. If the actual borrowings are in excess of maximum permissible borrowings as permitted by Method II, the excess portion should be transferred to Working Capital Term Loan (WCTL) to be repaid by the borrower by half yearly installments maximum within a period of 5 years. Interest on WCTL should normally be more than interest on a cash credit facility.

(3) The committee has suggested that there should be attempts to inculcate more discipline and planning consciousness among the borrowers, their needs should be met on the basis of quarterly projections submitted by them. Excess or under utilisation beyond tolerance limit 10% should be treated as irregularity and corrective action should be taken.

(4) The committee has suggested that the banks should appraise and fix separate limits for normal non-peak levels and also peak levels. It should be done in respect of all borrowers enjoying the banking credit limits of more than Rs. 10 lakhs.

(5) The committee suggested that the borrowers should be discouraged from approaching the banks frequently for ad hoc and temporary limits in excess of sanctioned limits to meet unforeseen contingencies. 

Requests for such limits should be considered very carefully and should be sanctioned in the form of demand loans or non-operating cash credit limits. Additional inter­est of 1% pa should be charged for such limits.


Working Capital Management – Operating Cycle

The concept of ‘Operating Cycle’ is very relevant in this context. As it has been stated above, one form of working capital is converting itself into another form. The whole process starts from the point of acquiring the raw material. The raw material is then converted into work in process or semi-finished goods which then get converted into finished goods.

The sale of finished goods result in receivables and then the receivables convert into cash and the whole cycle is then complete and repeats itself again and again. This cycle is known as the ‘Operating Cycle’. It is, in fact, a cycle from cash to cash. We start from cash by paying for the raw material and finally end when we receive the cash from the short term debtors.

The different activities and stages of an operating cycle can be presented as follows: 

In the above circular diagram we see what are the different stages of current assets and what are the activities which convert one stage of current asset into another. The activities are shown by arrows and the stage of the current asset is shown by short lines.

First we start by ‘cash’. The cash is used to purchase the raw material. The raw material is processed and manufactured to become first the semi-finished goods and then the finished goods inventory. The finished goods are sold to convert into receivables. Then, finally, the receivables convert themselves into cash and then the cycle keeps repeating itself. 

The time taken to convert ‘cash into cash’ is called the operating cycle. This may be a period of few days to one month or several months. It is obvious that longer the operating cycle, greater will be the amount of working capital at any point of time.

Sometimes a distinction is made between the operating cycle and the cash cycle. In the above illustration both are assumed to be the same. But the cash cycle may be different from this operating cycle. When we get suppliers credit, we do not pay cash when we purchase the raw material. We pay it after some time. This reduces the cash cycle. 

For example, if the operating cycle is 90 days and we are receiving suppliers’ credit on the purchase of raw material for, say, 20 days then the cash cycle will be 70 days only.

This concept of working operating cycle is very crucial to determining working capital requirement and the management of all these elements of working capital individually and in totality is known as ‘Working Capital Management’. 

The working capital is required because of the time gap between the sales and their actual realization in cash. This time gap is technically termed as “operating cycle” of the business.

In case of a manufacturing company, the operating cycle is the length of time necessary to complete the following cycle of events:

(i) Conversion of cash into raw materials;

(ii) Conversion of raw materials into work-in-process;

(iii) Conversion of work-in-process into finished goods;

(iv) Conversion of finished goods into accounts receivable; and

(v) Conversion of accounts receivable into cash.

This cycle will be repeated again and again.


Sources of Financing Working Capital 

The decision to finance the working capital of an organization is taken by the management after considering all the sources and applications of funds. An organization having less working capital may suffer loss of goodwill.

Let us discuss the sources of financing working capital in brief:

Source # 1. Bank Credit:

Refers to a short-term source of financing working capital. The bank credit can take the forms of cash credit, bank overdrafts, and discounting of bills. It is the most simple and reliable source for financing working capital. In addition, bank credit is used to raise a low amount of working capital for meeting daily needs.

Generally, small organizations use bank credit to finance their working capital as their requirements arc low. Bank credit is a type of secured loans (organizations have to mortgage their assets against these loans) and interest has to be paid on them till the time of maturity.

Source # 2. Loans from Financial Institutions:

Refer to a long-term source of financing working capital. Generally, large organizations need a big amount of loans for the long term. Such loans are provided by major financial institutions, such as ICICI and IDBI. 

Large organizations undertake huge projects for which bank credits are not sufficient; therefore, they prefer these loans to finance their projects. These loans are not preferred by small organizations as their turnover is insufficient to pay back these loans.

Source # 3. Public Deposits:

Refer to the source of financing working capital whose maturity period is more than one year and less than three years. This source is useful for an organization in meeting working capital needs of medium- term projects.

Source # 4. Prepaid Income:

Refers to the income that is received in the form of advance payments from distributors. Prepaid income is the most economical source to finance the working capital as the organization does not need to pay interest to distributors on prepaid income.

Source # 5. Retained Earnings:

Refer to reserve funds that are maintained by an organization. Retained earnings are the most reliable source of financing working capital as they can be raised at the time of need without any delay. The organization has no obligation to mortgage its assets fur using these funds. 


Methods Followed in Determining Working Capital Requirements (With Example and Solution)

The methods which are usually followed in determining working capital requirements are given below:

a. Conventional Method:

According to the conventional method, cash inflows and outflows are matched with each other. Greater emphasis is laid on liquidity and greater importance is attached to current ratio, liquidity ratio etc. which pertain to the liquidity of a business.

b. Operating Cycle Method:

In order to understand what gives rise to differences in the amount of timing of cash flows, we should first know the length of time which is required to convert cash into resources, resources into final products, the final product into receivables and receivables back into cash.

We should know, in other words, the operating cycle of an enterprise. The length of the operating cycle is a function of the nature of a business.

There are four major components of the operating cycle of a manufacturing company-

(a) The cycle starts with free capital in the form of cash and credit, followed by investment in materials, manpower and the services;

(b) Production phase;

(c) Storage of the finished products terminating at the time-finished product is sold;

(d) Cash or accounts receivable collection period, which results in, and ends at the point of dis-investment of the free capital originally committed.

New free capital then becomes available for productive reinvestment. When new liquid capital becomes available for recommitment to productive activity, a new operating cycle begins.

This method is more dynamic and refers to working capital in a realistic way. Different components of working capital are directed scientifically in order that the fullest utilisation of plant and machinery may be made.

This method helps in increasing the profitability of a business. It enables a company to maintain its liquidity and preserve that liquidity through profitability. The operating cycle method considers production and other business operations, and forecasts the changes that may be necessary in the pursuit of the future activities.

To meet the day-to-day requirements of the trade, the need for working capital may be assessed by finding out the period during which liquid funds, except cash and bank balances would be locked up in current assets after deducting the credit received from the suppliers and the other credits received.

The operating cycle concept can be made clear with the following example:

Exhibit:

In other words, if the operating expenditure during the year is Rs.5,00,000, each operating cycle will cost the business Rs.2,00,000. It is clear that the company will be interested in reducing the operating cycle period as much as possible.

Working capital is an investment in current assets. Like other investments, it costs money and therefore, is a drain on the profit. But the fact that working capital is a cost centre that it is an area with significant cost and that it needs an effective cost analysis and the control system is generally overlooked.

The cost analysis and control system, however, commonly covers one segment of the working capital- the raw material inventory. Like the one-eyed deer, the management keeps watch only on this cost point; and where this has been practised, it has, like the one-eyed deer, invited danger from the other side of current assets, that is, the work-in-process and finished goods.

How the absence of a control system for finished products (automobiles) resulted in a crisis of liquidity for General Motors Ltd. in the twenties is an example which it will be worthwhile for the firm’s management to remember.

A company may indeed have a factory which is well equipped with modern machines and which has excellent sales at profit-yielding prices. The company may not, however, be able to sustain production in top gear, and thus lose sales, customers and consequently profitable business, if it suffers from the want of working capital.

In fact, improper management or lack of working capital management may lead to the failure and even closure of a business undertaking.


Distribution of Working Capital

In 1987-88, the Reserve Bank of India conducted a study on the finance of 417 public limited companies.

The overall pattern of distribution of working capital was:

Inventories – 42.13 per cent;

Loans, advances, investments and book debts – 52.27 per cent;

Cash and Bank balances – 5.6 per cent.

With the exception of tea plantations, metal mining, construction and shipping industries, the cost of materials is very high, averaging around 60 percent and in some cases, touching 90 per cent.

In the sugar, woolen textiles, and engineering industries and in transport equipment, electrical and machine building and construction industries, inventories have been turned over less than three times in a year.

The average inventory held is more than two years’ needs in the shipping and construction industries, about one and half year’s needs in tea plantations and one year in metal mining.

Inventory accounts for a substantial portion of the current assets except in tea, paper, trading, shipping and hotel industries, where it is from 20 per cent to 40 per cent. On an average, inventories constitute about 40-60 per cent of the current assets. Ofcourse, there are exceptions-such as shipping, where the percentage is low. In a majority of the cases, it is more than 50.

The experience in various industries indicates that inventories constitute an average of 90 percent of the net working capital. This emboldens one to say that managing working capital is synonymous with controlling inventories.


Estimation of Working Capital Requirement (With Proforma and Reasons)

Working capital is the life-blood and the controlling nerve centre of a business. No business can run successfully without an adequate amount of working capital. To avoid the shortage in working capital, an estimate of working capital requirements should be made in advance so that arrangements can be made to procure adequate working capital.

Proforma for Estimation of Working Capital 

Notes: Profits should be ignored while calculating working capital requirements for the following reasons:

1. Profits may or may not be used as working capital.

2. Even if profits are to be used for working capital it has to be reduced by the amount of income tax, drawings, and dividend paid etc.

3. Calculation of work-in progress depends upon its degree of completion as regards to material, labour and overheads. However, if nothing is given in a question as regards to the degree of completion, we suggest the students to take 100% cost of material, labour and overheads.

4. Calculation for stocks of finished goods and debtors should be made at cost unless otherwise asked in the question.


Top 3 Sources of Working Capital – Long-term financing, Short-term financing and Spontaneous Financing

There are three sources of working capital – 

I. Long-term financing 

II. Short-term financing 

III. Spontaneous Financing

The need of working capital is increased by raising prices of end-products and relative inputs. On the other hand, the government and monetary authorities play their own role to curb the malice in periods of inflation. 

The control measures often take the form of dear money requirements in such an environment becomes a real problem to a finance manager of a concerned unit. Commercial banks play the most significant role in providing working capital finance, particularly in the Indian context.

In the view of the mounting inflation, the Reserve Bank of India has taken up certain fiscal measures to check the money supply in the economy. The balancing need has to be managed either by long-term borrowings or by issuing equity or by earning sufficient profits and retaining the same for coping with the additional working capital requirements. 

The first choice before a finance manager, when a part of additional working capital is not provided by banks, is to take the long-term sources of finance.

Source # I. Long-Term Financing:

1. Loans from Financial Institutions:

The option is normally ruled out, because financial institutions do not provide finance for working capital requirements. Further this facility is not available to all companies. For small companies, this option is not practical.

2. Floating of Debentures:

The probability of a successful floatation of debentures seems to be rather meagre. In Indian capital market, floating of debentures has still to gain popularity. Debenture issues of companies in the private sector not associated with certain reputed groups generally fail to attract investors to invest their funds in companies. The mode of raising funds by issuing convertible debentures/bonds is also gaining ground.

3. Issue of Shares:

With a view to financing additional working capital needs, issues of additional equity shares could be considered. Many Indian companies have still to go ahead to command respect of investors in this context. Low profit margin as well as lack of knowledge about the company make the success of a capital issue very dim.

4. Raising Funds by Internal Financing:

Raising funds from operational profits poses problems for many companies, because prices of their end-products are controlled and do not permit companies to earn profits sufficient to pay reasonable dividend and additional working assets; still a largely feasible solution lies in increasing profitability through cost control and cost reduction measures managing the cash operating cycle, rationalising inventory stocks, and so on.

Source # II. Short-Term Financing:

Short-term financing refers to those sources of short-term credit that the firm must arrange in advance. These sources include short-term bank loans, commercial papers and factoring of receivables.

Source # III. Spontaneous Financing:

Spontaneous financing refers to the automatic sources of short-term funds. The major sources of such financing are trade credit (creditors and bills payable) and outstanding expenses. Spontaneous sources of finances are cost free. 

Therefore, a firm would like to finance its current assets from spontaneous sources as much as possible. Every firm is expected to utilise spontaneous sources to the fullest extent. Thus, the real chance of financing current assets (not financed through spontaneous sources) is between short-term and long-term sources.


Working Capital Policies –  Restricted Policy, Relaxed Policy, Moderate Policy and Risk-Return Trade off (With Figure, Problem and Solution)

The degree of current assets that a company employs for achieving a desired level of sales is manifested in working capital policy. The higher the level of investment in current assets represents the liberal working capital policy, in which the risk level is less and also the marginal return is also lesser.

The determination of level of investment in current assets is dependent on risk-return perception of the management. In practice, the business concerns follow three forms of working capital policies which are discussed in brief in relation with figure 9.3. 

a. Restricted Policy:

It involves the rigid estimation of working capital to the requirements of the concern and then forcing it to adhere to the estimate. Deviations from the estimate are not allowed and the estimate will not provide for any cushion for contingencies and unexpected events. When the company adopts ‘restricted policy’, for a sales level of ‘S’ it maintains the current assets level of ‘C’.

Under this policy the company maintains lower investments in current assets, represents aggressive approach, intends to yield high return and accepts higher risk. The management is ready to counter any financial difficulties arising out of restricted policy. In restricted policy, the level of investment in current assets is lesser and high risk is perceived for increase of marginal return on investment.

b. Relaxed Policy:

It involves the allowing of sufficient cushion for fluctuations in funds requirement for financing various items of working capital. The estimate is made after taking into account the provision for contingencies and unexpected events. Under relaxed policy, the company maintains current assets upto the level of ‘C2‘ for the same level of sales (S) as in restricted policy.

This policy represents conservative approach. It allows the company to have sufficient cushion for uncertainties, contingencies, seasonal fluctuations, changes in activity levels, changes in sales etc. The level of investment in current assets is high, which results in lesser return, but the risk level is also reduced.

c. Moderate Policy:

The working capital level estimated in between the two extremes i.e. restricted and relaxed policies. In moderate policy, the investment in currents lies in between ‘C’ and ‘C2‘. With this policy, the expected profitability and risk levels fall between relaxed policy and restricted policy.

Problem:

An engineering company is considering its working capital investment for the year 2015-16. The estimated fixed assets and current liabilities for the next year are Rs.6.63 crore and Rs.5.96 crore respectively. The sales and earnings before interest and taxes (EBIT) depend on investment in its current assets – particularly inventory and receivables.

The company is examining the following alternative working capital policies: 

Calculate the following for each policy:

(a) Rate of return on Total assets,

(b) Net working capital position,

(c) Current assets to Fixed assets ratio, and

(d) Discuss the risk-return trade-off of each working capital policy.

Solution:

(d) Risk-Return Trade off:

The net working capital or current ratio is a measure of risk. Rate of return on total assets is a measure of return. The expected risk and return are minimum in the case of conservative investment policy and maximum in the case of aggressive investment policy. The firm can improve profitability by reducing investment in working capital.


Working Capital Management under Inflation – Components, Inventories and Aspects

Working capital management under inflation is described below:

Components

The main components of working capital are: 

i. Cash and bank balances 

ii. Inventories 

iii. Sundry debtors 

iv. Sundry creditors 

During inflation, these components of working capital are affected. The impact of inflation on each of the components is examined. 

Cash and bank balance and inflation.

When inflation takes place, cash and bank balances would be reduced in intrinsic value. 

More amount would be spent to discharge a liability in an inflationary period. Therefore, there should not be any idle cash or bank balances. This must be used in timely discharging of an overdue liability. 

In case there is no liability to be discharged, the surplus cash must be gainfully invested, i.e, put into the bank for a short-term time deposit for six months. 

Inventories and inflation 

Inventories comprise of: 

i. Raw materials 

ii. Stories and spares 

iii. Stores in process 

iv. Finished goods 

Inflation would not affect the valuation of the inventories of raw materials, stores and spares and stock-in-process, as these are valued at cost. 

However, the same would be affected, when the valuation is done on the basis of weighted average cost. 

Weighted average cost of stores and spares would be affected with the inflation. 

Inventory of finished goods would be affected, if the selling price is lower than the cost and the selling price is affected by the inflation. As long as the selling price is lower than the cost, the benefit of inflation in the price would be available in the valuation of finished products. 

Aspects

Besides the valuation aspect of inventories and the consequential impact of cost and prices, there are following aspects of working capital management during inflation: 

i. Level of inventories should be kept at the optimum level, when the prices are on the increase due to inflation 

ii. Procurement must be made to the minimum and to the needs 

iii. Consumption must be monitored  

iv. All techno-economic norms in the production process must be reviewed for any possible   improvement.


Finance Manager and Working Capital

In order to achieve the objective of maintaining satisfactory level of working capital in a firm, the finance manager has to perform the following two functions:

I. Forecasting the working capital requirements

II. Finding the sources of working capital

I. Forecasting the working capital requirements

An adequate amount of working capital is essential for the smooth running of a firm. The finance manager should forecast working capital requirements carefully to determine the optimum level of investment in working capital. While forecasting working capital requirements, it should be borne in mind that working capital requirements are to be determined on an average basis and not at any specific point of time.

The following two methods are generally adopted to forecast the working capital requirements:

1. Operating cycle method

2. Estimation of components of working capital method

1. Operating cycle method:

One of the methods for forecasting working capital requirements is based on the concept of operating cycle. When goods are sold on credit as is the normal practice of business firms today to cope with increased competition, the sale of goods cannot be converted into cash instantly because of time lag between sales and realisation of cash.

As there is a time lag between sales and realisation of receivables, there is a need for sufficient working capital to deal with the problem which arises due to lack of immediate realisation of cash against goods sold. The operating cycle is the length of time required for conversion of non-cash assets into cash.

This operating cycle refers to the time taken for the conversion of cash into raw materials, raw materials into work-in-progress, work-in-progress into finished goods, finished goods into receivables, receivables into cash and this cycle repeats. This cycle is also known as working capital cycle or cash cycle.

The operating cycle length differs from firm to firm. If a firm has a lengthy production process or a firm has liberal credit policy, the length of the operating cycle will be more. On the other hand, if a firm is a trading concern, then the length of the operating cycle will be reduced to a greater extent.

The following diagrams will make this concept more clear: 

Significance of Operating cycle

(a) Surplus generation:

It represents the activity cycle of business i.e., purchases, manufacture, sales and collection thereof. Hence, the operating cycle stands for the process that creates surplus or profit for the business.

(b) Funds rotation:

It indicates the total time required for rotation of funds. The faster the funds rotate, the better it is for the firm.

(c) Going concern:

It lends meaning to the going concern concept. If the cycle stops in between, the going concern assumption may be violated. Hence, the operating cycle should be on par with the industry average. A long cycle indicates overstocking of inventories or delayed collection of receivables and is considered unsatisfactory.

Computation of operating cycle

The operating cycle can be determined as given below: 

The various components of operating cycle can be calculated by using following formula given below:

(i) Raw materials storage period 

(ii) Work-in-progress holding period 

(iii) Finished goods storage period: 

(iv) Debtors collection period: 

(v) Creditors payment period: 

Computation of required working capital

After having ascertained the period of one operating cycle, total number of operating cycles that can be completed during a year can be computed by dividing 365 days with the number of operating days in a cycle. The total operating expenditure in the year when divided by the number of operating cycles in a year will give the average amount of working capital required.

2. Estimation of components of working capital method

As the working capital is the excess of current assets over current liabilities, the working capital requirements can be determined by estimating the amounts of different constituents of working capital e.g., inventories, debtors, cash, accounts payable, outstanding expenses and prepaid expenses etc.

The various constituents of working capital have a direct bearing on the computation of working capital and the operating cycle. The holding period of various constituents of operating cycle may either contract or expand the net operating cycle period. Shorter the operating cycle period, lower will be the requirement of working capital and vice versa.

(A) Estimation of current assets

The estimates of various components of working capital may be made as follows:

(i) Stock of raw materials:

Every manufacturing firm has to maintain some stock of raw materials in stores in order to meet the requirement of the production process. The funds to be invested in stock of raw materials can be determined on the basis of production budget, the estimated cost per unit and average holding period of stock of raw materials by applying the following formula: 

(ii) Stock of work-in-progress:

In any manufacturing firm, the production process is continuous and is generally consisting of several stages. At any particular point of time, there will be different number of units in different stages of production. Some of these units may be 10% complete, some may be 60% complete and some may be even 99% complete.

These units, which can neither be defined as raw materials nor as finished goods, are known as work-in-progress (or) semi-finished goods. The process time taken to convert materials into finished goods determine the investment needed for the work-in-progress.

It includes the materials, labour and overheads incurred for work-in-progress. It may be presumed that the material cost is incurred initially and the labour and overheads content of work-in-progress are spent uniformly. Thus it is customary to take full cost of materials and half the cost of labour and overheads for the processing period as work-in-progress.

The funds to be invested in work-in-progress can be estimated by using the following formula:

Raw materials = 

(iii) Stock of finished goods:

In most of the cases, some goods remain in stores for sometime before they are sold. Such unsold goods are called stock of finished goods. The cost which is already incurred in purchasing or production of these units is locked up and hence working capital is required for them. The period for which finished goods are expected to be in store determines the amount needed to finance the stock of finished goods.

 (iv) Trade debtors:

The term ‘Trade debtors’ represents the persons who have purchased goods on credit from the firm and have not paid for the goods sold to them. Goods sold on credit and credit period allowed to debtors are the determinants of the amount needed to finance debtors.

 (v) Minimum desired cash and bank balances to be maintained by the firm is to be included in the current assets for the computation of working capital.

(B) Estimation of current liabilities

Current liabilities generally affect computation of working capital. Hence, the amount of working capital is lowered to the extent of current liabilities (other than bank credit) arising in the normal course of business.

The important current liabilities like trade creditors and outstanding expenses can be estimated as follows:

(i) Trade creditors:

The suppliers of goods on credit to the firm are known as its trade creditors. Credit extended by suppliers and the period of delay permitted are the determining factors to estimate the liability to creditors.

(ii) Outstanding expenses:

Expenses like wages and overheads may be delayed by a few weeks in their payment.

Note: In case of selling overheads, the relevant item would be sales volume instead of production volume.


4 Agencies Responsible for Managing Working Capital Components 

The agencies responsible for managing the working capital components in an organisation

(i) Cash and bank balances:

 a. Finance and Accounts Department

(ii) Inventories:

a. Materials Management Department

b. Production Planning and Control Department

c. Sales and Marketing Department

d. Finance and Account Department

(iii) Receivables (Sundry Debtors):

a. Sales and Marketing Department

b. Finance and Accounts Department

(iv) Sundry Creditors:

a.  Materials Management Department

b.  Raw Materials Department

c.  Production Planning and Control Department

d.  Finance and Accounts Department.


Working Capital in New Projects and their Aspects 

New projects may be of two types:

i. Green field projects

ii. Projects in the running organisation (brown field projects)

In the running organisation, the requirement of working capital can be met either from the

existing operation or the additional working capital can be adjusted. There may not be any

problem to meet the additional working capital.

However, in the case of a green field project, the requirement of the working capital would be totally new. Additional funds would have to be arranged for the working capital. Green field project means a project in a new area, a first time construction, for example, a small car company being constructed by TATA in a new location.

Norm for the requirement of working capital in the case of a new project is twenty-five per cent of estimated cost of production, i.e., three months cost of production. Out of the total requirement of working capital so worked out, there may be a margin money to meet the immediate need of working capital.

This is worked out at the rate of twenty-five per cent of the total working capital. The margin money is included in the capital cost and the funding of the same is done along with the capital cost of the new project.

Norm of three months cost of production for working capital is on the basis of assumption that time taken from spending on raw material, labour, operating materials and stories, overheads, etc., and its conversion to finished products will take two months.

Thereafter to sell and realise cash from the customers will take another one month. Thus, from spending to receiving, time taken would be three months.

Similarly, the norm of 25% of the working capital has been assumed as a margin money for working capital This is an assumption that the minimum amount of working capital would always remain in the process, therefore, margin money is to be financed from the long-term fund.

Management aspects

Management aspects related to working capital in the new projects are:

i. To arrange funds timely and in the required quantity at reasonable terms and conditions.

ii. To assess the working capital requirement prudently.

iii. To spend the working capital funds economically adhering to the principles of management as discussed

iv. Working capital funds should be monitored on a regular basis.


Policies to put Control over Working Capital 

The notion of working capital management came into existence when RBI attempted to identify major weaknesses in the way banks finance the working capital needs of organizations. The banks finance the working capital requirement of organizations by providing them loans that are security-oriented rather than end-use oriented.

It was easy for organizations having sufficient securities to take loans; whereas, others experienced the shortage of funds. Therefore, the organizations with the shortage of funds suffer from lower capacity utilization, high cost of production, and threat of shut down.

RBI framed its policy to put control over working capital by considering the recommendations of various committees, which are as follows:

1. Dahejia Committee:

Refers to the committee that was appointed in October 1968 to analyze the extent of credit needs of various industries. There were two recommendations of this committee. The first recommendation was that banks should not only consider security but also the total financial position of an organization.

The second recommendation was that an organization should hold a minimum level of raw materials, finished goods, and stock to maintain a certain level of production. In addition, this minimum level of raw materials, finished goods, and stock should be considered by banks before the issuance of loans.

2. Tandon Committee:

Refers to the committee that was appointed in August 1975 under the chairmanship of Mr. P. L. Tandon. This committee determined the quantum of bank advances to the industries at different stages and reduced the dependence of borrowers on bank loans by improving their current ratio.

Following were the recommendations of this committee:

i. Allows the banks to finance up to 75% of the working capital gap. The remaining 25% should come from long-term funds.

ii. Allows the borrower to finance the 25% of the current assets out of long-term funds. The remaining 75% should be financed by the bank.

iii. Introduces the concept of core current assets, which are imperative for the production of goods. The committee suggested that the borrower should finance 75% of the entire amount of core current assets. The borrower finances the one-fourth part of the core current assets from the long-term funds and other three-fourth part from the short-term funds. The rest of the 25% may be financed by the banks.

3. Chhore Committee:

Refers to the committee that was appointed in April 1979 under the chairmanship of Mr. K. B. Chhore to review the cash credit management policy of banks.

Following were the recommendations of this committee:

i. Requires that borrowers should enhance their own contribution in working capital. If the actual borrowings are in the excess of maximum permissible limit then the excess portion should be considered Working Capital Term Loan (WCTL). This term loan should be repaid by the borrower in half yearly installments maximum within a period of five years. Interest on WCTL should normally be more than the interest on cash credit facilities.

ii. Attempts to inculcate more discipline and planning consciousness among the borrowers.

iii. Requires the banks to appraise and fix normal and upper limits for providing working capital. It should be done in respect of all borrowers enjoying the banking credit limits of more than Rs.10 lacs.

4. Marathe Committee:

Refers to the committee that was appointed in 1982 to review Credit Authorization Scheme (CAS), which came into existence in 1965. As per the recommendations of Marathe Committee in 1988, CAS was replaced by Credit Monitoring Agreement (CMA). In addition, according to CMA, the banks were supposed to report RBI for the sanctions or renewals of the credit limits beyond the prescribed amount.

5. Nayak Committee:

Refers to the committee, which gave the recommendation that the evaluation of the working capital requirements of rural, cottage, and small-scale industries should have a maximum limit of up to Rs.50 lacs. 

The working capital requirement of these units should be considered to be 25% of their projected turnover. Out of the total working capital requirement, 20% is supposed to be introduced by the units as their margin money requirement and the remaining 80% can be financed by banks.

6. Vaz Committee:

Refers to the committee whose recommendations were added in the Nayak Committee’s recommendations. The recommendations of both Nayak and Vaz committees have been accepted by RBI and all the organizations. As per the recommendations of these two committees, the requirement of working capital has nothing to do with the level of current assets and current liabilities. 


Effects of Excessive and Inadequate Working Capital 

Effects of Excessive Working Capital:

Optimum amount of Working Capital should be maintained within the firm, so that there is neither excessive Working Capital nor inadequate Working Capital. Excessive Working Capital or inadequate Working Capital both have an evil effect on the growth of a firm.

The evil effects of excessive working capital have been discussed below:

1. Excessive Working Capital leads to increase in inventory level due to high production and low sales leading to daring consequences such as – theft, loss, damage and wastage.

2. Increase in idle funds thereby indicates inability in generation of profit by a firm.

3. Huge amount of idle funds indicates incapability of the firm in utilizing resources optimally, i.e., underutilization of resources of the firm.

4. Excessive Working Capital indicating underutilization of fund may motivate the management of the firm to involve in speculative activities.

5. Excessive Working Capital may induce a firm to provide credit to debtors liberally. Liberal credit to the debtors will result in an increase in size of accounts receivable and delay in collection from debtors.

6. Excessive Working Capital is an indication of the Overcapitalization, i.e., amount of capital more than the actual requirement.

7. The balance between profitability and liquidity may be distorted due to excessive Working Capital.

8. Excessive Working Capital may make the management inefficient in increasing production capacity and further expansion of the firm.

All these are the evil effects of excessive Working Capital. Similar to excessive Working Capital, inadequate Working Capital also has an evil effect on the business.

Effects of inadequate working capital have been stated below:

1. Failure to meet short-term obligations due to inadequate funds may lead to loss of reputation, credit worthiness of the firm.

2. A firm becomes insolvent, i.e., becomes incapable to repay Current Liabilities within stipulated time due to inadequate Working Capital.

3. Inadequate Working Capital makes a firm incapable to undertake profitable projects.

4. Inadequate Working Capital prevents a firm from earning profit since it cannot undertake its entire operation plan.

5. Inadequate Working Capital signifies weak liquidity position of the firm, i.e., incapability to meet day-to-day obligations.

Both excessive and inadequate Working Capital have negative impacts on the firm. So neither excessive Working Capital nor inadequate Working Capital is desirable.


Inefficiency in Working Capital Management – Overtrading, Under Capitalization and Over Capitalization

Inefficiency in working capital management is described below:

a. Overtrading:

Overtrading arises when a business expands beyond the level of funds available. Overtrade means an attempt to finance a certain volume of production and sales with inadequate working capital. If the company does not have enough funds of its own to finance stock and debtors, if it wishes to expand then it is forced to borrow from creditors and from banks in the form of overdraft.

Sooner or later such expansion, financed completely by the funds of others, will lead to a chronic imbalance in the working capital ratio. A firm should always maintain adequate working capital to support its sales activity. Overtrading is a situation where a firm attempts to increase its sales level without having a support of adequate working capital.

The overtrading situation will lead to high pressure on liquidity and the firm would feel difficult in paying creditors within the credit period allowed. This in turn would lead to difficulty in procurement of raw materials and services in time. This will adversely affect the production process and the firm will be forced to slow down its activity.

This in turn will adversely affect the working capital position and ultimately it leads to negative profitability of the firm. Therefore, the overtrading should be detected in time and remedial action should taken either to increase the availability of working capital to match the increased sales level or the firm should slow down its activity level to the working capital available with the firm. Expansion is advantageous so long as the business has the funds available to finance the stocks and debtors involved.

Overtrading begins at the point where the business relies on extra trade credit and increased turnover are financed by taking longer periods of credit from suppliers and/or negotiating and extension of overdraft limits with the bank. 

Overdependence on outside finance is a sign of weakness, unless the expansion is curtailed, suppliers may refuse credit beyond certain limits, and the bank may call for a reduction of the overdraft.

If this happens, the business may be insolvent in that it does not have sufficient liquid resources (cash) to pay for current operations or to repay current liabilities until customers pay for sales made on credit terms, or unless stock is sold at a loss for immediate cash payment.

b. Under Capitalization:

Under capitalization is a situation where the company does not have funds sufficient to run its normal operations smoothly. This may happen due to insufficient working capital or diversion of working capital funds to finance capital items.

If the company faces the situation of under capitalization, it will suffer from the following disadvantages:

I. The firm will face difficulties in meeting current obligations and in meeting day to day running expenses.

II. It is unable to procure raw materials and stores items in time.

III. The long-term fixed assets cannot be utilized at optimum level.

IV. The return on capital employed would be lower due to lower capacity utilization.

V. The firm will face difficulty in meeting the delivery schedules, causing loss of goodwill as well as prolonged operating cycle.

VI. The discounts on cash purchases and bulk purchases cannot be obtained by a cash starved concern.

The Finance manager should take immediate and proper steps to overcome the situation of under capitalization by making arrangements of sufficient working capital.

The measures suggested to overcome the situation of under capitalization are as follows:

I. Prepare the realistic cash flow and funds flow statements.

II. Retain the profits earned in the business.

III. The fixed assets which are not contributing to return on capital employed should be disposed off to increase cash resources.

IV. Steps may be taken to raise long-term funds through issue of shares, debentures or raise long-term loans from banks and financial institutions.

V. Increase the inventory turnover ratio.

VI. Revise and reduce the credit collection policies and procedures.

VII. Concentrate on core business activities and divest the unprofitable segments and units.

c. Over Capitalization:

If there are excessive stocks, debtors and cash, and very few creditors, there will be an over investment in current assets. The inefficiency in managing working capital will cause this excessive working capital resulting in lower return on capital employed and long-term funds will be unnecessarily tied up when they could be invested elsewhere to earn profit.


Just-In -Time (JIT) as a Strategic Approach in Working Capital Management (With Principles)

Just-In -Time (JIT) – A strategic management approach in working capital management:

Inventory is a major part of working capital. JIT is practised in the management of inventory. JIT is known as a philosophy and not as technique. JIT originated in the USA. However, it was developed and practiced- more in Japan.

That is why it is known as Japanese method of integrated philosophy for elimination of waste of any kind, viz., waste of time, waste of labour, waste of raw materials, and waste of overheads and so on which does not add value to the product or service.

In India too, JIT is practiced in Maruti Udyog, Indian Defence (partially successful) and cycle manufacturing factories in Ludhiana in the Punjab.

Principles of JIT

Main principles of JIT functioning are:

i. Reduction of set up times

ii. Increased use of sequential flow processes

iii. Increased use of multifunction workers

iv. Preventive maintenance to be regular job than to attend to break down maintenance

v.  Use of flexible tools and maintenance equipments and with full capacity utilisation

vi. Proper production planning and scheduling

vii. Long-term relationship with customers

viii. To have state-of-art technology in use

ix. Continuous employees educational and on the job training programmes

x. Strict quality control

xi. Defects free production process

xii. Regular analysis of causes of defects and remedial actions

xiii. Information system based on customers

Thus, the true spirit of JIT philosophy is to produce when sell and procure when produce. With the use of JIT philosophy, inventory level comes down to minimum level and thus reduces the blocking of money in the surplus inventories. This ultimately helps in better working capital management.


3 Important Theoretical Terms in Working Capital Management 

Working capital management primarily refers to the aspect of managing short-term assets and liabilities.

Let us look at three theoretical terms:

i. Debtors (accounts receivable)

ii. Creditors (account payable)

iii. Inventory

i. Unpaid bills against invoices submitted to clients for goods or services delivered are defined as debtors or accounts receivables.

ii. Bills that remain as outstanding to be paid by the enterprise to the vendor or supplier is termed as creditors or accounts payable.

iii. Inventory refers to resources or material stored up by the enterprise to ensure timely production or delivery of goods or services. These could be raw materials such as iron, steel, sand, etc., or people on a bench. 

Inventory management refers to the cost benefit analysis that the manager makes between holding inventory and its related costs. The longer one holds the inventory, the costlier it becomes. This is because the unused materials represent locked up cash – unless these materials are used up to produce the product, cash cannot enter the system.

Unless cash trapped in these three accounts are carefully monitored and managed one may find themselves short of cash in times of need. Understanding operating cash cycle and internal source of cash could unearth places where one can find locked up cash for release.


Difference Between Working Capital Management and Capital Budgeting 

Difference between working capital management and capital budgeting is given below:

Difference # Working Capital Management:

1. It is related to investment in Current Assets.

2. The goal of working capital management is to determine the optimum quantum of investment in working capital and to maintain liquidity at a satisfactory level.

3. Such decisions have short-term implications.

4. Such decisions are repetitive in nature.

5. These are related to deployment of a small amount of funds.

6. These decisions involve low degree of risk.

7. The decisions are easy to make.

Difference # Capital Budgeting:

1. It is related to investment in long-term Assets.

2. The goal of capital budgeting is the deployment of available capital for the purpose of maximising the long-term profitability of the firm.

3. Such decisions have long-term implications i.e. the effect of such decisions will be felt by the firm over a long time span.

4. Such decisions are infrequent and these are not easily reversible.

5. These are related to deployment of large amounts of funds.

6. These decisions involve a high degree of risk because future benefits are uncertain.

7. These decisions are difficult to make because they require an assessment of future events which are uncertain and difficult to predict.


Difference between Fixed Assets and Current Assets

From the financial management point of view, the nature of fixed assets and current assets differs from each other in the following respects:

(1) The fixed assets are required to be retained in the business over a period of time and they yield’ the returns over their life, whereas the cur­rent assets lose their identity over a short period of time, say one year.

(2) In case of current assets it is always necessary to strike a proper balance between the liquidity and profitability principles which is not the case with fixed assets. E.g. If the size of current assets is large, it is always beneficial from the liquidity point of view as it ensures smooth and fluent business operation.

Sufficient raw material is always available to cater to the production needs, sufficient finished goods are available to cater to any kind of demand of customers, liberal credit period can be offered to the custom­ers to improve the sales, sufficient cash is available to pay off the creditors and so on. 

However, if the investment in current assets is more than what is ideally required, it affects the profitability as it may not be able to yield sufficient rate of return on investment.

On the other hand, if the size of current assets is too small, it always involves the risk of frequent stock out, inability of the company to pay its dues in time etc. As such, the invest­ment in current assets should be optimum. 

Hence, it is necessary to man­age the individual components of current assets (viz., stock, receivables and cash) in a proper way. Thus, working capital management refers to proper administration of all aspects of current assets and current liabilities.

Working capital management is concerned with the problems arising out of the attempts to manage current assets, current liabilities and the inter-re­lationship between them. The intention is not to maximize the investment in working capital nor is it to minimize the same. The intention is to have optimum investment in working capital.

In other words, it can be said that the aim of working capital management is to have minimum investment in working capital without affecting the regular and smooth flow of operations. The level of current assets to be maintained should be sufficient enough to cover its current liabilities with a reasonable margin of safety.

Moreover, the various sources available for financing working capital re­quirements should be properly managed to ensure that they are obtained and utilised in the best possible manner.


Advantages of Working Capital

No business can run successfully without an adequate amount of working capital, business needs adequate liquid resources in order to pay salaries, creditors and to ensure regular supplies to carry the production process. To remain in business, it is essential that a firm successfully manage its working capital. Proper management of working capital helps to improve a firm’s liquidity position and financial health and reduces risk.

The main advantages of working capital are as follows:

Advantage # 1. Improve Production Efficiency:

Adequate working capital ensures that a firm has sufficient working capital to cover the requirements that are linked to its production activities. Production process involves transforming raw-materials into outputs of finished goods.

A firm’s productive capacity is the total level of output or production that it could produce in a given time period. In order to utilize the productive capacity continuous supply of raw material, research and development and expansion programmes successfully be carried out if adequate working capital is maintained in the business.

Advantage # 2. Easy Obtaining Loan:

Working Capital indicates relation between current assets and current liability of the concern. Excess of current assets over current liabilities of a company is an important indicator of a company’s financial health that reflects a business organization’s ability to pay off its short term obligations at most when requests come from suppliers.

A firm with positive working capital means high solvency and this means a company can easily avail loans for additional working capital from banks and financial institutions in easy and favourable terms.

Advantage # 3. Exploitation of Business Opportunity:

Working capital can help an enterprise to exploit new business opportunities. Timely availability of funds meets the needs for additional working capital helping enterprises to develop plans and take advantage of business opportunities with a stable source of capital. In some cases, a firm may be able to exploit investment opportunities without worrying about sources of capital. 

Without working capital, business may fail capitalise opportunities of today’s ever growing and rapidly evolving business world. Working capital finance plans allow business to have the safety of the financial backing it needs.

Advantage # 4. Entrusts Security and Confidence:

The adequacy of cash and current assets together with their efficient handling of working capital resources literally determines worry less environment for management of business enterprise in terms of working-capital challenges like slow-paying customers or extended payment terms and coping with fluctuations in business.

Thus sufficient working capital entrusts a sense of security, confidence and loyalty, not only throughout the business itself, but also among its customers, creditors and other stakeholders of business.

Advantage # 5. Measure of Solvency:

Solvency is the ability to meet debt obligations as they come due. To determine the solvency level of a firm according to existing obligations, we must assess the working capital position of a firm, if the firm has inadequate working capital, it is said to be under-capitalized. Such a firm runs the risk of insolvency.

This is because, paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities. Therefore in order to maintain the solvency of the business, it is essential that the sufficient amount of working capital is reserved to meet debt obligations.

Advantage # 6. Managing Reputation:

Reputation establishes goodwill of business & regarded as a quantifiable asset. Financial reputation of the firm increases due to efficiency of working capital. A firm always will be able to pay money to its creditors, dividend to shareholder, salaries to its employees only if it has sufficient liquid funds and timely meeting these obligations develops and increases the reputation of the business. 

Further it is interesting to note that firms with liquid cash resources can create and sustain good demand for their products and enjoy profitable marketing conditions.

Advantage # 7. Contingency Management:

In today’s economy, companies face up and downs due to enduring uneven growth and significant cash flow constraints. For most of a company’s crisis such as recession, technological changes, competition etc., can curtail its operations resulting in a credit crunch that threatens their very existence.

To overcome this problem company’s look up to effective management of working capital requirements through planning, obtaining additional facilities and restructuring their operations. Thus various crises can easily be resolved, if a company maintains adequate working capital.

Advantage # 8. Cash Discount:

Cash discounts are incentives offered by sellers for either making immediate payment on sale or for paying a bill owed before the scheduled due date. The seller will usually reduce the amount owed by the buyer by a small percentage. In this context a business can avail the advantage of cash discount by paying cash for its purchases and this is only possible if a proper cash balance is maintained. Further by availing a discount a firm can reduce the cost of production.

Advantage # 9. Meet Routine Obligations:

Working capital is very essential to maintain the smooth running of a business. A firm with sufficient working capital is able to pay suppliers and other creditors, pay employees, pay for raw materials and to provide goods for customers to buy now, but pay later (so-called “trade debtors”). Thus sufficient working capital helps a business to sustain its operations.


10 Symptoms of Poor Working Capital Management 

Symptoms of poor working capital management are:

In general, the following cases are seen in inefficient management of working capital: 

I. Excessive carriage of inventory over the normal levels required for the business will result in more balance in trade creditors accounts. More creditors balances will cause strain on the management in management of cash. 

II. Working capital problems will arise when there is a slowdown in the collection of debtors. 

III. Sometimes, capital goods will be purchased from the funds available for working capital. This will result in shortage of working capital and its impact is on operations of the company. 

IV. Unplanned production schedules will cause excessive stocks or failures in meeting dispatch schedules. 

V. More funds kept in the form of cash will not generate any profit for the business. 

VI. Inefficiency in using potential trade credit require more funds for financing working capital. 

VII. Overtrading will cause shortage of working capital and its ultimate effect is on the operations of the company. 

VIII. Dependence on short-term sources for financing permanent working capital causes lesser profitability and will increase strain on the management in managing working capital. 

IX. Inefficiency in cash management causes embezzlement of cash. 

X. Inability to get working capital limits will cause serious concern to the company and, sometimes, may turnout to be sick.


Adequacy and Inadequacy of Working Capital

Working capital should be adequate for the following reasons:

(i) It protects a business from the adverse effects of shrinkage in the values of current assets.

(ii) It is possible to pay all the current obligations promptly and to take advantage of cash discounts.

(iii) It ensures to a greater extent the maintenance of a company’s credit standing and provides for such emergencies as strikes, floods, fires etc.

(iv) It permits the carrying of inventories at a level that would enable a business to serve satisfactorily the needs of its customers.

(v) It enables a company to extend favourable credit terms to customers.

(vi) It enables a company to operate its business more efficiently because there is no delay in obtaining materials etc. because of credit difficulties.

(vii) It enables a business to withstand periods of depression smoothly.

(viii) There may be operating losses or decreased retained earnings.

(ix) There may be excessive non-operating or extraordinary losses.

(x) The management may fail to obtain funds from other sources for purposes of expansion.

(xi) There may be an unwise dividend policy.

(xii) Current funds may be invested in non-current assets.

(xiii) The management may fail to accumulate funds necessary for meeting debentures on maturity.

(xiv) There may be increasing price necessitating bigger investments in inventories and fixed assets.

When working capital is inadequate, a company faces the following problems:

(i) It is not possible for it to utilise production facilities fully for the want of working capital.

(ii) A company may not be able to take advantage of cash discount facilities.

(iii) The credit-worthiness of the company is likely to be jeopardised because of the lack of liquidity.

(iv) A company may not be able to take advantage of profitable business opportunities.

(v) The modernisation of equipment and even routine repairs and maintenance facilities may be difficult to administer.

(vi) A company will not be able to pay its dividends because of the non-availability of funds.

(vii) A company cannot afford to increase its cash sales and may have to restrict its activities to credit sales only.

(viii) A company may have to borrow funds at exorbitant rates of interest.

(ix) Its low liquidity may lead to low profitability in the same way as low profitability results in low liquidity.

(x) Low liquidity would positively threaten the solvency of the business. A company is considered illiquid when it is not able to pay its debt on maturity. It must be wound up under Section 433 of the Companies Act, 1956, upon its inability to pay its debts.


Problems Raised by Excessive Working Capital

Too much working capital is as dangerous as too little of it.

Excessive working capital raises the following problems:

(i) A company may be tempted to overtrade and lose heavily.

(ii) A company may keep very big inventories and tie up its funds unnecessarily.

(iii) There may be an imbalance between liquidity and profitability

(iv) A company may enjoy high liquidity and, at the same time, suffer from low profitability.

(v) High liquidity may induce a company to undertake greater production which may not have a matching demand. It may find itself in an embarrassing position unless its marketing policies are properly adjusted to boost up the market for its goods.

(vi) A company may invest heavily in its fixed equipment which may not be justified by actual sales or production. This may provide a fertile ground for later over-capitalisation.

(vii) Excessive working capital may be as unfavourable as inadequacy of working capital because of the large volume of funds not being used productively. Ralph Kennedy and McMullen have observed that the availability of excess working capital may lead to carelessness about costs, and therefore, to inefficiency of operations.

Irrespective of the arguments opposed to the accumulation of excess amounts of working capital, the trend among business firms is towards the achievement of greater liquidity of assets.

Repeated experience with business fluctuations, wide price movements and rapid technological changes have impelled management of major companies to follow conservative financial policies by piling up excessive working capital.

A determination of the adequacy of working capital poses a problem both to the corporate body and the banking sector. The complicated nature of the problem seems to have been well appreciated by both; and the banking sector finances the working capital needs of the corporation even out of the limited resources at its disposal.


Working Capital Management – Multiple Choice Question and Answers 

Q1. Which of the following is a current asset?

a. Building

b. Shares

c. Plant and machinery

d. Bills receivables

Ans. d

Q2. Which of the following is a current liability?

a. Sundry creditors

b. Debentures

c. Cash

d. Term-loans

Ans. a

Q3. Net working capital is represented as:

a. Current assets + Current liabilities

b. Assets + Liabilities

c. Current assets – Current liabilities

d. Assets – Liabilities

Ans. c

Q4. The type of working capital required by the food processing industry is:

a. Temporary working capital

b. Seasonal working capital

c. Permanent working capital

d. Special working capital

Ans. b

Q5. In case of labor intensive industries, an organization needs:

a. More working capital

b. Less working capital

c. No working capital

d. Moderate working capital

Ans. a

Q6. When the suppliers of raw material give credit facility for long-term, then the requirement of working capital is:

a. More

b. Moderate

c. Less

d. Almost zero

Ans. c

Q7. Which of the following is a source of financing working capital requirement?

a. Human resource

b. Bank credit

c. Selling of fixed assets

d. Liquidation

Ans. b

Q8. When distributors pay in advance to purchase finished goods, it is called:

a. Prepaid expenses

b. Marginal cost

c. Current liabilities

d. Prepaid income

Ans. d

Q9. Loans from financial institutions are generally preferred by:

a. Large organizations

b. Small organizations

c. Cottage industries

d. Small-scale industries

Ans. a

Q10. When an organization has high turnover, then it needs:

a. More working capital

b. Less working capital

c. No working capital

d. Moderate working capital

Ans. b

Q11. Who made an attempt to identify major weakness in the financing of working capital?

a. SBI

b. HDFC

c. Ministry of finance

d. RBI

Ans. d

Q.12. Dahejia Committee was appointed by RBI in:

a. October 1966

b. October 1967

c. October 1968

d. October 1969

Ans. c

Q13. Tandon Committee was appointed by RBI in:

a. August 1972

b. August 1973

c. August 1974

d. August 1975

Ans. d

Q14. Tandon Committee was appointed under the chairmanship of:

a. Mr. P. L. Tandon

b. Mr. K. B. Tandon

c. Mr. Narayan Murty

d. Mr. Dhirubhai Ambani

Ans. a

Q15. Chhore Committee was appointed by RBI in:

a. April 1978

b. April 1979

c. April 1980

d. April 1981

Ans. b

Q16. Chhore Committee was appointed under the chairmanship of:

a. Mr. P. L. Tandon

b. Mr. K. B. Chhore

c. Mr. Narayan Chhore

d. Mr. Dhirubhai Ambani

Ans. b

Q17. Marathe Committee was appointed by RBI in:

a. 1980

b. 1981

c. 1982

d. 1983

Ans. c

Q18. Marathe Committee was appointed to review:

a. CMA

b. CAS

c. Long-term capital policy

d. Primary market

Ans. b

Q19. CAS was replaced by:

a. SEBI

b. RBI

c. SBI

d. CMA

Ans. d

Q20. Vaz Committee extended the recommendations of:

a. Marathe Committee

b. Tandon Committee

c. Nayak Committee

d. Chhore Committee

Ans. c


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