WCM/U1 Topic 7 Overview of Working Capital Management
Working Capital Management implies the management of current assets and current liabilities. Considering the importance of working capital, we can very well, say that the management of wording capital is very significant and should be efficient to keep the business going smoothly.
To be more explicit, working capital management includes proper handling of inventories, accounts receivable, cash and bank and liabilities such as accounts payable, outstanding expenses etc. In a big manufacturing organization, working capital occupies a pre-eminent position. Over half the total assets consists of working, capital. So its management deserves careful consideration.
The financial management today, because of various complexities in the market and competitive business environment, finds it necessary to deal with working capital in two parts — overall management and management of each item separately.
Overall management of working capital requires proper estimation of working capital needed for the business, ratios of investments on different items of current assets and proper policy as to the rate of profit earning, possibility of loan procurement, advances etc.
One point is worth noting regarding management of working capital. Since working capital consists of varieties of items, management of one in the desirable way may affect another. For instance, making prompt and regular payments of bills receivable may affect cash balance and the company may face difficulties in liquid cash.
Liquidity, flexibility is to be balanced in working capital management in such a wise and prudent way that the over-all management of the working capital contributes to the general welfare of the company.
Profitability, liquidity, flexibility all is important in managerial exercises but a happy compromise of these factors is no easy task. Financial astuteness is absolutely necessary to ensure a brilliant bright-forward management of working capital.
A deep study of the trend of business is absolutely essential to keep the business on right track. It is all the more important to plan the ratio of different items of working capital in the best interest of the company.
It may be that the outside creditors are to be satisfied in the interest of the company but at the same time requisite amount of cash balance must always be kept ready for day-to-day compliance of various obligations. Working capital management formulates policy that is based on experience.
If the policy of the top management is to ensure more profit, then more money is blocked in inventories and cash becomes depleted. It may create problem. Income of the company may suffer if more money is kept always ready to meet any current obligation. Obviously, idle cash does not earn any income.
In regard to cash in hand, working capital management is rather difficult and needs very careful consideration. A company is likely to face an adverse situation if the principles of liquidity and profitability are rigorously followed. Small cash in hand cripples a company to meet the obligation of creditors on demand.
In such a situation small suppliers will be naturally reluctant to supply raw materials to such a company and as a consequence the company will have production difficulty. This will lead to fewer sales and less profit. Therefore, a very balanced ratio profitability and liquidity will have to be maintained through sound management.
It emerges from the above discussion that it is rather impracticable to draw up any invariable standard for the management of working capital. And it also transpires that cash is the major and very sensitive component of working capital, so the working capital management is, as a matter of fact, the management of cash (liquidity) with reference to profitability.
To conclude, working capital management is the planning and controlling of current assets (assets convertible into cash). Working capital indicates circular flow of cash (cash flow cycle). From cash to inventories to receivables and back to cash.
The two concepts of working capital are net working capital and gross working capital. Net working capital is a qualitative concept; the management will also get an idea about the ease and cost of raising working capital. Net working capital is measured by the current ratio viz. current assets/current liabilities.
\Normally the current ratio should be 2: 1. A larger ratio indicates greater solvency and vice versa. Of course, excessive current ratio would point out poor financial planning and it would reduce income.
The concept of gross capital is a financial concept whereas that of net concept is an accounting concept. For the management more interest is in the amount of current assets with which it has to operate. “However, in an ever changing economy it is very difficult to secure perfect equilibrium between inflow and outflow of cash”.
So, enough supply of working capital is the objective of sound financial management. While aiming at sound working capital management, certain factors must always be kept in mind.
(a) Nature of business,
(b) Size of business,
(c) Terms of purchase and sale,
(d) Turnover of inventories,
(e) Process of manufacture,
(f) Importance of labour,
(g) Proportion of raw material to total costs,
(h) Cash requirements,
(i) Seasonal variations,
(j) Banking connections,
(k) Growth and expansion.
In gross sense working capital means the total of current assets and in net sense it is the difference between current assets and current liabilities.
Through working capital management, the finance manager tries to manage the current assets, current liabilities and to evaluate the interrelationship that exists between them, i.e. it involves the relationship between a firm’s short-term assets and short-term liabilities.
The aim of working capital management is to deploy such amount of current assets and current liabilities so as to maximize short-term liquidity. The management of working capital involves managing inventories, accounts receivable and payable as also cash.
The two steps involved in the working capital management are as follows:
(i) Forecasting the amount of working capital; and
(ii) Determining the sources of working capital.
Apart from the two mentioned above the following two additional important aspects should be kept in mind while managing working capital:
(a) Inclusion of Profit:
There is a lot of controversy regarding inclusion of profit in working capital requirement forecast. There are two views. The first view suggests that profit should be included in the working capital. The second view suggests that it should not be included. Inclusion or exclusion of profit depends primarily on the managerial policy adopted by the firm.
From the first view, if working capital is calculated on the basis of actual cash outflow then profit should not be included in calculating working capital because financing of profit is not required.
From the second view, where balance sheet approach is adopted for calculating working capital, profit element is not ignored as this should be included in the amount of debtors.
(b) Exclusion of Depreciation:
Depreciation does not involve any actual cash outflow, so it should not be included in the estimation of working capital.