Sustainable Growth Rate, Working Capital: (Management, approaches and estimation)
SUSTAINABLE GROWTH RATE
The sustainable growth rate (SGR) is the maximum rate of growth that a firm can sustain without having to expand financial leverage or look for outside financing. For a firm operating above its SGR, sustaining growth can be difficult in the long term due to strained financial resources or overextended financial leverage, in which case the firm should borrow funds to facilitate prolonged growth. Meanwhile, firms that fail to attain their SGR are at risk of stagnation.
When Growth Exceeds the SGR
There are cases when a company’s growth becomes greater than what it can self-fund. In these cases, the company must devise a financial strategy that sells more equity, increases financial leverage through debt, reduces dividend payouts, increases profit margins or decreases the asset to sales ratio. Any of these factors can increase the SGR.
Working Capital Management
Working capital management is the way a company manages the relationship between assets and liabilities in the short term. Simply put, working capital management is how a company manages its money for day to day operations as well as any immediate debt obligations. When managing working capital, the company has to manage accounts receivable, accounts payable, inventory, and cash. The goal of working capital management is to have adequate cash flow for continued operations and have the most productive usage of resources.
Working capital management refers to a company’s managerial accounting strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities, to ensure the most financially efficient operation of the company. The primary purpose of working capital management is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
Working capital management commonly involves monitoring cash flow, assets and liabilities through ratio analysis of key elements of operating expenses, including the working capital ratio, collection ratio and the inventory turnover ratio. Efficient working capital management helps with a company’s smooth financial operation, and can also help to improve the company’s earnings and profitability. Management of working capital includes inventory management and management of accounts receivables and accounts payables.
WORKING CAPITAL APPROACHES
(A) Matching or hedging approach: This approach matches assets and liabilities to maturities. Basically, a company uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets.
Example: A fixed asset which is expected to provide cash flow for 5 years should be financed by approx 5 years long-term debts. Assuming the company needs to have additional inventories for 2 months, it will then seek short term 2 months bank credit to match it.
(B) Conservative approach: Conservative approach is a risk-free strategy of working capital financing. A company adopting this strategy maintains a higher level of current assets and therefore higher working capital also. The major part of the working capital is financed by the long-term sources of funds such as equity, debentures, term loans etc. So, the risk associated with short-term financing is abolished to a great extent.
It is conservative because the company prefers to have more cash on hand. That is why, fixed and part of current assets are financed by long-term or permanent funds. As permanent or long-term sources are more expensive, this leads to “lower risk lower return”.
(C) Aggressive approach: The Company wants to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.
The aggressive approach is a high-risk strategy of working capital financing wherein short-term finances are utilized not only to finance the temporary working capital but also a reasonable part of the permanent working capital. In this approach of financing, the levels of inventory, accounts receivables and bank balances are just sufficient with no cushion for uncertainty. There is a reasonable dependence on the trade credit.
WORKING CAPITAL ESTIMATION
The following points highlight the top three methods of working capital estimation. The methods are:
- Percentage of Sales Method
- Regression Analysis Method
- Operating Cycle Method.
(1) Percentage of Sales Method
It is a traditional and simple method of determining the level of working capital and its components. In this method, working capital is determined on the basis of past experience. If, over the years, the relationship between sales and working capital is found to be stable, then this relationship may be taken as a base for determining the working capital for future.
This method is simple, easy to understand and useful for projecting relatively short-term changes in working capital. However, this method cannot be recommended for universal application because the assumption of linear relationship between sales and working capital may not hold good in all cases.
(2) Regression Analysis Method
It is a useful statistical technique applied for forecasting working capital requirements. It helps in making working capital requirement projections after establishing the average relationship between sales and working capital and its various components in the past years. The method of least squares is used in this regard.
(3) Operating Cycle Method
The operating cycle concept can be used in estimation of working capital. The longer the length of operating cycle, the higher the requirement for working capital and vice versa.