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INTRODUCTION

Working Capital Management


Concept:-
Effective financial management is the outcome, among other things, of good
management of investment of funds in business. Funds can be invested for long-term
purposes such as acquisition of fixed assets, diversification and expansion of business,
modernisation of plants & machinery, and research & development. Funds are also needed
for short-term purposes, that is, for daily operations of the business. For example, if you are
managing a manufacturing unit you will have to arrange for procurement of raw material,
payment of wages and for meeting regular expenses.
All the goods, which are manufactured in a given time period may not be sold in that
period. Hence, some goods remain in stock, e.g., raw material, semi-finished (manufacturing
-in-process) goods and finished goods. Funds are thus blocked in different types of inventory.
Again, the whole of the stock of finished goods may not be sold against ready cash; some of
it may be sold on credit. The credit sales also involve blocking of funds with debtors till cash
is received or the bills are cleared. Credit sales are also known as account receivables.
Different industry types require different levels of working capital. Service industries
need little to no inventory whereas retailers need more. Depending on the retailer’s business
their inventory will also vary. Manufacturers will probably require more because they need
raw material stocks, work‐in‐progress and finished goods. Retailers may sell for cash
therefore having few receivables and producers may have trade customers and have greater
receivables.
Working Capital refers to firm's investment in short-term assets, viz. cash, short-term
securities, debtors and inventories of raw materials, work-in-process and finished goods. It
can also be regarded as that part of the firm's total capital, which is employed in short term
operations. It refers to all aspects of current assets and current liabilities. In simple words, we
can say that working capital is the investment needed for carrying out day-today operations of
the business efficiently. The management of working capital is as important as that of long-
term financial investment. The aim of working capital management is to achieve balance
between having sufficient working capital to ensure that the business is liquid but not too
much that the level of working capital reduced profitability.
Significance of Working Capital:-
There is no running business firm, which does not require some amount of working
capital. Working capital management is essential for the long‐term success of a business. No
business can survive if it cannot meet its day‐to‐day obligations. A business must therefore
have clear policies for the management of each component of working capital. Even a fully
equipped manufacturing firm is sure to fail without an adequate supply of raw materials to
process, cash to meet the wage bill, the capacity to wait for the market for its finished
products, and the ability to grant credit to its customers.
Similarly, a firm in service sector or a commercial enterprise is virtually good for
nothing without merchandise to sell. Working capital, thus, is the life-blood of a business. As
a matter of fact, any firm, whether profit-oriented or otherwise, will not be able to carry on
day-to-day activities without sufficient working capital.

Kinds of Working Capital:-

Ordinarily, working capital is classified into two categories:


I. Fixed, Regular or Permanent Working Capital; and
II. Variable, Fluctuating, Seasonal, Temporary or Special Working Capital

I. Fixed Working Capital


The need for current assets is associated with the operating cycle, which, as you
know, is a continuous process. As such, the need for current assets is felt constantly. The
magnitude of investment in current assets however may not always be the same. The need for
investment in current assets may increase or decrease over a period of time according to the
level of production. Nevertheless, there is always a certain minimum level of current assets,
which is essential for the firm to carry on its business irrespective of the level of operations.
This is the irreducible minimum amount necessary for maintaining the circulation of the
current assets. This minimum level of investment in current assets is permanently locked up
in business and is therefore referred to as permanent or fixed or regular working capital. It is
permanent in the same way as investment in the firm's fixed assets is.
II. Fluctuating Working Capital
Depending upon the changes in production and sales, the need for working capital,
over and above the permanent working capital, will fluctuate. The need for working capital
may also vary on account of seasonal changes or abnormal or unanticipated conditions. For
example, a rise in the price level may lead to an increase in the amount of funds invested in
stock of raw materials as well as finished goods. Additional doses of working capital may be
required to face cutthroat competition in the market or other contingencies like strikes and
lockouts. Any special advertising campaigns organised for increasing sales or other
promotional activities may have to be financed by additional working capital. The extra
working capital needed to support the changing business activities is called the fluctuating
(variable, seasonal, temporary or special) working capital.

Figure 1: Permanent and Temporary Working Capital

As seen in Figure 1, that fixed working capital is stable over time, where as variable working
capital is fluctuating-sometimes increasing and sometimes decreasing. The permanent
working capital line, however, may not always be horizontal. Both these kinds of working
capital - permanent and temporary, are required to facilitate production and sales through the
operating cycle, but temporary working capital is arranged by the firm to meet liquidity
requirements that are expected to be temporary.

Approaches to Managing Working Capital;-


Two approaches are generally followed for the management of working capital: (i) the
conventional approach, and (ii) the operating cycle approach.
i. The Conventional Approach
This approach implies managing the individual components of working capital (i.e.
inventory, receivables, payables, etc) efficiently and economically so that there are neither
idle-funds nor paucity of funds. Techniques have been evolved for the management of each
of these components. In India, more emphasis is given to the management of debtors because
they generally constitute the largest share of the investment in working capital. On the other
hand, inventory control has not yet been practiced on a wide scale perhaps due to scarcity of
goods (or commodities) and ever rising prices.

ii. The Operating Cycle Approach


This approach views working capital as a function of the volume of operating
expenses. Under this approach the working capital is determined by the duration of the
operating cycle and the operating expenses needed for completing the cycle. The duration of
the operating cycle is the number of day involved in the various stages, commencing with
acquisition of raw materials to the realisation of proceeds from debtors. The credit period
allowed by creditors will have to be set off in the process. The optimum level of working
capital will be the requirement of operating expenses for an operating cycle, calculated on the
basis of operating expenses required for a year.
In India, most of the organizations use to follow the conventional approach earlier,
but now the practice is shifting in favor of the operating cycle approach. The banks usually
apply this approach while granting credit facilities to their clients.
Inventory Management
Concept:-
“Inventory" to many business owners is one of the more visible and tangible aspects
of doing business. Raw materials, goods in progress and finished goods all represent various
forms of inventory. Each type represents funds tied up until the inventory leaves the company
as purchased products. Likewise, merchandise stocks in a retail store contribute to profits
only when their sale puts money into the cash account.
In a literal sense, inventory refers to stocks of anything necessary to do business.
These stocks represent a large portion of the business investment and must be well managed
in order to maximize profits. In fact, many businesses cannot absorb the types of losses
arising from weak inventory management. Unless inventories are controlled, they are
unreliable, inefficient and costly.

Inventory management should focus on:-


 There should be proper accounting and physical controls.
 The inventory should be stored properly to avoid the losses.
 Fixation of inventory levels like minimum, maximum and reorder levels and
 economic order quantity to ensure the optimum levels of stocks.
 Proper care should be taken to avoid stock out situations.
 Continuous supply of material should be ensured at the right time and right cost.
 The investment in inventory should be optimized by avoiding over stocking.

Successful Inventory Management:-


Successful inventory management involves balancing the costs of inventory with the
benefits of inventory. Many business owners fail to appreciate fully the true costs of carrying
inventory, which include not only direct costs of storage, insurance and taxes, but also the
cost of money tied up in inventory (opportunity cost). This fine line between keeping too
much inventory and not enough is not the manager's only concern. Others include:
 Maintaining a wide assortment of stock -- but not spreading the rapidly moving ones
too thin;
 Increasing inventory turnover -- but not sacrificing the service level;
 Keeping stock low -- but not sacrificing service or performance.
 Obtaining lower prices by making volume purchases -- but not ending up with slow-
moving inventory; and
 Having an adequate inventory on hand -- but not getting caught with obsolete items.

The degree of success in addressing these concerns is easier to gauge for some than for
others. For example, computing the inventory turnover ratio is a simple measure of
managerial performance. This value gives a rough guideline by which managers can set goals
and evaluate performance, but it must be realized that the turnover rate varies with the
function of inventory, the type of business and how the ratio is calculated (whether on sales
or cost of goods sold).
Cash Management

Management of cash is an important function of the finance manager. It is concerned with the
managing of:-
 Cash flows into and out of the firm;
 Cash flows within the firm; and
 Cash balances held by the firm at a point of time by financing deficit or investing
surplus cash.

Objectives of cash management:-


The main objectives of cash management for a business are:-
 Provide adequate cash to each of its units;
 No funds are blocked in idle cash; and
 The surplus cash (if any) should be invested in order to maximize returns for the
business.
A cash management scheme therefore, is a delicate balance between the twin objectives of
liquidity and costs.

The Need for Cash:-


The following are three basic considerations in determining the amount of cash or liquidity as
have been outlined by Lord Keynes:
Transaction need: Cash facilitates the meeting of the day-to-day expenses and other debt
payments. Normally, inflows of cash from operations should be sufficient for this purpose.
But sometimes this inflow may be temporarily blocked. In such cases, it is only the reserve
cash balance that can enable the firm to make its payments in time.
Speculative needs: Cash may be held in order to take advantage of profitable opportunities
that may present themselves and which may be lost for want of ready cash/settlement.
Precautionary needs: Cash may be held to act as for providing safety against unexpected
events. Safety as is explained by the saying that a man has only three friends an old wife, an
old dog and money at bank.
Receivables Management
Management of trade credit is commonly known as Management of Receivables.
Receivables are one of the three primary components of working capital, the other being
inventory and cash, the other being inventory and cash. Receivables occupy second important
place after inventories and thereby constitute a substantial portion of current assets in several
firms. The capital invested in receivables is almost of the same amount as that invested in
cash and inventories. Receivables thus, form about one third of current assets in India. Trade
credit is an important market tool. It acts like a bridge for mobilization of goods from
production to distribution stages in the field of marketing. Receivables provide protection to
sales from competitions. It acts no less than a magnet in attracting potential customers to buy
the product at terms and conditions favourable to them as well as to the firm. Receivables
management demands due consideration not financial executive not only because cost and
risk are associated with this investment but also for the reason that each rupee can contribute
to firm's net worth.

Meaning and Definition:-


When goods and services are sold under an agreement permitting the customer to pay
for them at a later date, the amount due from the customer is recorded as accounts
receivables. So, receivables are assets accounts representing amounts owed to the firm as a
result of the credit sale of goods and services in the ordinary course of business. The value of
these claims is carried on to the assets side of the balance sheet under titles such as accounts
receivable, trade receivables or customer receivables. This term can be defined as "debt owed
to the firm by customers arising from sale of goods or services in ordinary course of
business."

According to Robert N. Anthony, "Accounts receivables are amounts owed to the


business enterprise, usually by its customers. Sometimes it is broken down into trade
accounts receivables; the former refers to amounts owed by customers, and the latter refers to
amounts owed by employees and others".

Generally, when a concern does not receive cash payment in respect of ordinary sale
of its products or services immediately in order to allow them a reasonable period of time to
pay for the goods they have received. The firm is said to have granted trade credit. Trade
credit thus, gives rise to certain receivables or book debts expected to be collected by the firm
in the near future.

In other words, sale of goods on credit converts finished goods of a selling firm into
receivables or book debts, on their maturity these receivables are realized and cash is
generated. According to Prasanna Chandra, "The balance in the receivables accounts would
be; average daily credit sales x average collection period." The book debts or receivable
arising out of credit has three dimensions:

 It involves an element of risk, which should be carefully assessed. Unlike cash sales
credit sales are not risk less as the cash payment remains unreceived.
 It is based on economics value. The economic value in goods and services passes to
the buyer immediately when the sale is made in return for an equivalent economic
value expected by the seller from him to be received later on.
 It implies futurity, as the payment for the goods and services received by the
buyer is made by him to the firm on a future date.

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