Working Capital Management

Introduction
Topics like Capital Structure, Capital Budgeting, Dividend Policy etc. fall under the domain of long-term financial management.

Working Capital Management or short-term financial management is concerned with decisions relating to current assets and current liabilities.

The key difference between long-term financial management and short-term financial management is in terms of the timing of cash. Long-term financial decisions like buying capital equipment, issuing shares/ debentures etc. involve cash flows over an extended period of time (5-15 year or more). Short-term financial decisions typically involve cash flows within a year or within the operating cycle of the firm.

Concepts of Working Capital
Gross Working Capital: It refers to the total of all current assets.
Net Working Capital: It refers to the difference between current assets and current liabilities.

Current Assets
Inventories
Raw materials and Components
Work-in-process
Finished Goods
Trade Debtors
Loans and Advances
Cash and Bank Balances

Current Liabilities
Sundry Creditors
Borrowings (Short term)
Commercial Banks
Others
Provisions

Management of working capital refers to the management of current assets as well as current liabilities. The major thrust, is of course, is on the management of current assets. This is because, current liabilities arise in the context of current assets.

Working capital management is a significant facet of financial management. Its importance stems from two reasons

Investment in current assets represents a substantial portion of total investment.
Investment in current assets and the level of current liabilities have to be geared quickly to changes in sales.

The financial managers spend a great deal of time in managing the current assets and current liabilities. Arranging short term financing, negotiating favourable credit terms, controlling movement of cash, administering accounts receivables, monitoring the investment in inventories etc. consume a great deal of time of financial managers.

Types of Working Capital

Permanent working capital
Temporary or variable working capital

Permanent working capital
= minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities.

Permanent working capital = core current assets

Main features:
1. Amount of permanent working capital remains in the business in one form or other.
2. There is a positive correlation between the amount of permanent working capital and the size of the business.
3. Permanent working capital is permanently needed therefore it should be financed through long-term funds.

Temporary working capital:
The amount of temporary working capital fluctuates depending upon the changes in the production and sales.

Temporary working capital = fluctuating working capital = variable working capital

Adequacy of working capital
A firm must have adequate working capital. It should neither be excessive nor inadequate.

Excessive working capital is a situation where in the firm invests excessive funds in working capital. These excessive or idle funds earn no profit for the firm.

Dangers of Excess Working Capital

It may result in unnecessary accumulation of inventory which may lead to increase in wastage due to mishandling, theft etc.
It is an indication of defective credit policy. There is the possibility of higher incidence of bad debts.
It may lead to complacency in managing day-to-day expenses of the firm.
Executives may be tempted to spend more.

Inadequate working capital is a situation where in the firm does not have sufficient funds to meet day to day running expenses. This ultimately results in interruption in the production process.

Dangers of inadequate working capital

Operating inefficiencies creep in when it becomes difficult of meet day-to-day commitments.
It becomes difficult to implement operating plans and achieve firms targets.
It directly affects firms liquidity position and the firm may find it difficult to honour short-term obligations.

WC, Risk and Return
Higher level of WC decreases the risk as well as profitability. Lower level of WC increases the risk as well as the possibility of profitability.

Determinants of Working Capital

Nature of Industry
Seasonality of Operations
Production Policy
Market Conditions
Conditions of supply
Size of Business
Volume of Sales
Terms of Purchase and Sales
Business Cycle
Growth and Expansion of the firm
Fluctuations in the supply of Raw material
Price Level Changes
Operating Efficiency of the firm
Profit Appropriation
Capital Structure of the firm

Management of WC
The main objective of WC management is to manage the firms current assets and liabilities in such a way that a satisfactory level of working capital is maintained.

Current assets should be sufficient enough to cover current liabilities.
Different components of WC should be properly balanced.

WC Management policies have a great effect on a firm's profitability, liquidity and its structural health. The finance manager should therefore, chalk out appropriate WC Management Policies in respect of each of the components of WC so as to ensure higher profitability, proper liquidity, and sound structural strength.

In order to achieve this objective the Finance Manager has to perform two functions:

Estimating the amount of Working Capital (Need to take into account various factors that determine the working capital requirement)
Sources from which these funds have to be raised (Need to know type of WC required)

Components of Working Capital Management

Cash Management
Receivables Management
Inventory Management

Management of Cash
Cash, the most liquid asset, is of vital importance to the daily operations of business firms. Though the companies hold the assets in the form of cash less than 3%, its efficient management is crucial to the solvency of the business.

Motives for holding cash
John Maynard Keynes has put forth 3 possible motives for holding cash:

Transaction Motive
Precautionary Motive
Speculative Motive
[Compensation Motive: Banks provide certain basic services to their clients free of charge. The clients are asked to keep a minimum balance with them which helps them to earn interest and thus compensate them for the free services so provided]

Objectives of Cash Management
Two basic objectives:

To make cash payments
To minimize the amount locked up as cash balances

Basic Problems of Cash Management

Cash Planning
Managing the cash flows
Maintenance of optimal level of cash
Investment of surplus cash

Float
The cash balance shown by a firm in its books is called the book balance or ledger balance. The balance shown in its bank account is called the available balance or collected balance. The difference between the available balance and book balance is referred to as the float.

There are two kinds of float:
A] Disbursement float
B] Collection float

Cheques issued by a firm create disbursement float. Cheques received by a firm lead to collection float.

The Net Float is the sum of disbursement float and collection float. It is simply the difference between the firm's available balance and its book balance. If the net float is positive, it means that the available balance is greater than the book balance. If the net float is negative, the available balance is lesser than the book balance.

Since what matters is the available balance, the finance manager should try to maximize the net float. This means that the manager should strive to speed up collections and delay disbursements.