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Working Capital
Management – An Overview
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NATURE OF WORKING CAPITAL
Working capital management is concerned with the problems that arise in managing
the current assets (CA), current liabilities (CL) and the interrelationships between them.
Its operational goal is to manage the CA and CL in such a way that a
satisfactory/acceptable level of net working capital (NWC) is maintained.
Concepts and Definitions of Working Capital There are two concepts of working capital:
1) Gross and
2) Net
Gross Working Capital
Gross working capital means the current assets which represent the proportion of
investment that circulates from one form to another in the ordinary conduct of business.
Net Working Capital The term net working capital can be defined in two ways:
1) the most common definition of net working capital (NWC) is the difference
between current assets and current liabilities; and
2) alternate definition of NWC is that portion of current assets which is financed with
long-term funds.
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The task of the financial manager in managing working capital efficiently is to ensure
sufficient liquidity in the operations of the enterprise. The liquidity of a business firm is
measured by its ability to satisfy short-term obligations as they become due. The three basic
measures of a firm’s overall liquidity are
1) the current ratio,
2) the acid-test ratio, and
3) the net working capital
The Common Definition of NWC and its Implications
NWC is commonly defined as the difference between current assets and current liabilities.
Efficient working capital management requires that firms should operate with some amount of
NWC, the exact amount varying from firm to firm and depending, among other things, on the
nature of industry.
The NWC is necessary due to non-synchronous nature of expected cash inflows
and required cash outflows. The more predictable the cash inflows are, the less
NWC will be required and vice-versa. The NWC represents the liquidity position of
a firm.
Alternative Definition of NWC
NWC can alternatively be defined as that part of the current assets which are
financed with long-term funds. Since current liabilities represent sources of short-
term funds, as long as current assets exceed the current liabilities, the excess
must be financed with long-term funds.
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Working capital can be
1) Permanent and
2) Temporary
Permanent (fixed) Working Capital
Permanent working capital is a certain minimum level of working capital on a
continuous and uninterrupted basis.
Temporary (fluctuating/variable) Working Capital
Temporary (fluctuating/variable) working capital is the working capital
needed to meet seasonal as well as unforeseen requirements.
The basic distinction between permanent and temporary working capital is
illustrated in Fig. 2. Figure 2 shows that the permanent level is fairly constant, while
temporary working capital is fluctuating–increasing and decreasing in accordance
with seasonal demands. In the case of an expanding firm, the permanent working
capital line may not be horizontal. This is because the demand for permanent
current assets might be increasing (or decreasing) to support a rising level of
activity. In that case the line would be a rising one as shown in Fig. 3.
Both kinds of working capital are necessary to facilitate the sales process through
the operating cycle. Temporary working capital is created to meet liquidity
requirements that are of a purely transient nature.
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Working Capital
Amount of
Temporary
Permanent
Time
Temporary or
Amount of
fluctuating
Permanent
Time
The change in sales and operating expenses may be either in the form of an increase
or decrease. An increase in the volume of sales is bound to be accompanied by
higher levels of cash, inventory and receivables. The decline in sales has exactly the
opposite effect–a decline in the need for working capital. A change in the operating
expenses–rise or fall–has a similar effect on the levels of working capital.
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(2) Policy Changes
The second major cause of changes in the level of working capital is
because of policy changes initiated by the management. There is a wide
choice in the matter of current assets policy. The term current asset policy
may be defined as the relationship between current assets and sales
volume. A firm following a conservative policy in this respect having a very
high level of current assets in relation to sales may deliberately opt for a less
conservative policy and vice versa. These conscious managerial decisions
certainly have an impact on the level of working capital.
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Determinants of Working Capital
Working capital requirements are determined by a variety of factors. These factors,
however, affect different enterprises differently. In general, the factors relevant for proper
assessment of the quantum of working capital required are:
General Nature of Business
The working capital requirements of an enterprise are basically related to the conduct of
business. Enterprises fall into some broad categories depending on the nature of their
business. For instance, public utilities have certain features which have a bearing on their
working capital needs. The two relevant features are: (i) the cash nature of business, that
is, cash sale, and (ii) sale of services rather than commodities. In view of these features,
they do not maintain big inventories and have, therefore, probably the least requirement of
working capital. At the other extreme are trading and financial enterprises. The nature of
their business is such that they have to maintain a sufficient amount of cash, inventories
and book debts. They have necessarily to invest proportionately large amounts in working
capital.
Production Cycle
Another factor which has a bearing on the quantum of working capital is the production
cycle. The term ‘production or manufacturing cycle’ refers to the time involved in the
manufacture of goods. It covers the time-span between the procurement of raw materials
and the completion of the manufacturing process leading to the production of finished
goods. Funds have to be necessarily tied up during the process of manufacture,
necessitating enhanced working capital.
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Business Cycle
The working capital requirements are also determined by the nature of the business
cycle. Business fluctuations lead to cyclical and seasonal changes which, in turn,
cause a shift in the working capital position, particularly for temporary working capital
requirements. The variations in business conditions may be in two directions: (i)
upward phase when boom conditions prevail, and (ii) downswing phase when
economic activity is marked by a decline. During the upswing of business activity, the
need for working capital is likely to grow to cover the lag between increased sales and
receipt of cash as well as to finance purchases of additional material to cater to the
expansion of the level of activity. Additional funds may be required to invest in plant
and machinery to meet the increased demand. The downswing phase of the business
cycle has exactly an opposite effect on the level of working capital requirement.
Production Policy
The quantum of working capital is also determined by production policy. In the case of
certain lines of business, the demand for products is seasonal, that is, they are
purchased during certain months of the year.
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Credit Policy
The credit policy relating to sales and purchases also affects the working capital. The
credit policy influences the requirement of working capital in two ways:
Dividend Policy
Another appropriation of profits which has a bearing on working capital is dividend
payment. The payment of dividend consumes cash resources and, thereby, affects
working capital to that extent. Conversely, if the firm does not pay dividend but retains
the profits, working capital increases.
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Depreciation Policy
Depreciation policy also exerts an influence on the quantum of working
capital. Depreciation charges do not involve any cash outflows. The effect of
depreciation policy on working capital is, therefore, indirect.
Higher depreciation (enhanced rates of depreciations) has a positive impact
on WC for two reasons: (i) lower tax liability and, hence, more cash profits
and (ii) lower disposable profits and, therefore, a smaller dividend payment.
They imply more cash with a corporate.
Price Level Changes
Changes in the price level also affect the requirements of working capital.
Rising prices necessitate the use of more funds for maintaining an existing
level of activity. For the same level of current assets, higher cash outlays are
required. The effect of rising prices is that a higher amount of working capital
is needed.
Operating Efficiency
Efficiency of operations accelerates the pace of cash cycle and
improves the WC turnover resulting in reduced requirement of WC.
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