Working capital management is an important aspect of Business Organization, and it is all about the working capital management that company easily meet the day to day expenses of business. Before going in depth of working capital management, we should know about the working capital. The term “working capital” can be described into the further two ways. Gross working capital (Current Assets) and net working capital (Current Assets – Current Liabilities)
In general, working capital means gross working capital that includes all the current assets of a business like,
Current Assets = Accounts Receivable + Cash + Inventory + Marketable Securities
The “working capital” is different from the term “capital” which reflects the debt or equity in the capital structure theory. Today working capital has great importance in business and big companies hire special staff for the matters of working capital management. Below are is the importance of working capital that must be in your mind.
Importance of Working Capital Management
One major fact related to the importance of working capital is that it is the measure of the liquidity of the Business. This means that it tells that how easily a business can liquidate/sell its current assets to pay its current liabilities. For this purpose, some ratios are applied which are as follow.
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio or Acid Test Ratio = Current Assets – Inventory / Current Liabilities
- Working Capital Tradeoff:
Working capital management is an important area for any business management, which is related to decisions about how much money should be invested in each category of a current asset. There are certain advantages attached to each decision.
Advantages of Maintaining Large Current Assets
If a business makes a policy to maintain the larger proportion of current assets, then it avails the following advantages.
- The shortage of the raw material is reduced as sufficient cash is available for smooth working of the operations of the business.
- The liquidity ratio is high which serves as a healthy sign in the credit market.
Advantages of Maintaining Small Current Assets:
When a business decides to keep a less proportion of current assets, then it gets the following advantages.
- More money is utilized in productive assets, which results in an increase in the profitability of the business.
- The WACC or opportunity cost is reduced.
Working Capital Management Policies:
There is a strong requirement of the management to keep the optimum working capital for their business. For this purpose, there are certain policies which are as follow.
01- Relaxed Policy or “Fat Cat”:
It has the following characteristics.
- The main idea is to keep a larger portion of current assets, so that if a large order is placed by any customer, then that would not lost due to the deficiency of raw material.
- It results in the increase in the sales due to the credit sales to a lot of customers.
- The high liquidity & current ratio results in the effective credit rating in the market.
- Example includes Wall Mart store chains during the season of Christmas and New Year.
02- Restricted Policy or “Lean & Mean”:
Following are the main features of this policy.
- The basic principle is to keep the least amount of current assets, so that turnover could increase.
- The high turnover result in the higher profitability as the volume of sales is much higher.
- The storing & carrying cost of inventory is much lower.
- The WACC or opportunity cost of acquiring capital is much lower.
03- Policy of Zero Working Capital:
It is the extreme picture of the lean & mean policy in which the current assets are trying to be kept at a minimum level near to zero. The example of this policy is Japanese JIT (Just in Time) which specifies that the inventory is ordered or purchased just a few hours before getting the order from a customer.
04- Moderate Policy:
It lies between the “Lean & Mean” and “Fat Cat” policy.
In working capital management, the following three items are focused.
- Cash Management
- Inventory Management
- Accounts Receivable Management
01- Cash Management:
Cash is playing very important role in the business like,
- To meet the routine and unexpected expenses.
- To acquire trade discount
- Bills payment
- For liquidity purpose to hold good credit rating position.
On the other hand the business containing cash bears certain difficulties like,
- Cash held does not generate any return or revenue.
- In case of high interest rates, the opportunity cost related to holding cash increases.
In the balance sheet terms, “cash is king” which means that the bills are paid by cash only.
- Cash Budget (Short Term):
For effective cash management, cash budget is prepared by the management that takes into account the expected cash inflows and cash outflows in order to determine the monthly net cash shortfall or surplus. For this purpose, the credit purchases, credit sales and the projected cash collection time are taken into account.
In case of shortfall of net cash, the required short term financing is determined.
Cash Management Policies:
Following are different policies that are utilized by the management in order to effectively utilized of working capital management.
01- Interest Based Policy:
When the interest rates are higher in the market, then it is quite suitable to hold a minimum portion of cash. As the opportunity cost of holding cash raises and the idle cash does not generate any kind of revenue. The management of business tries to speed up their collections (recovery of cash from debtors) along with the increase in the marketable securities. Most of the excessive money is invested in the new projects that have positive NPVs.
02- Policy of Cash Flow Synchronization:
This is a cash management policy in which the cash inflows are synchronized with the cash outflows periodically in such a manner that cash incoming on a certain date is utilized to pay the bills/payments soon after. In other words the bills payable (etc.) are due 2 or 3 days after at a certain date of the month, when there is a projected cash inflows from activity, like collection from debtors (etc.). In this way an effective use of cash takes place, which does not require the holding of idle cash.
03- Speedy Collection Policy:
It is the cash management policy in which the collection from debtors is speeded up, so that the account receivables are recovered quickly. The business must sell its products or services on credit due to the strong competition in the market. There is another issue in the collection procedure of these debts. For this purpose, the management can use the following techniques.
- Hires the collection staff
- Write the letters to debtors
- Acquire the services of collection agencies
- Technology usage like automatic debit, electronic wire transfer etc.
04- Float Policy:
Float policy of cash management is related to maintain the track of the clearance of cheques from the banks. In the USA, 1 to 2 days are spent on their clearance of cheque from the date of depositing into the bank. The management makes a policy to quickly cash all the cheques that are being deposited into the bank account of the business. As the cheques are quickly cash, than the cheques given to creditors. So there is a net float of cash balance in the bank account that is positive and this surplus cash can be utilized to meet the emergency expenses.
02- Inventory management:
There are the three kinds of inventories which are as follow.
- Raw Material:
The inventory that is utilized in the production process to be converted into a final product/service is called raw material.
The inventory that is partially converted into final product is called work-in-process inventory.
- Finished Good:
The inventory that is in the shape of final product to be sale is called finished good.
Inventory Management Issues:
In the management of inventory, there are certain issues that should be effectively tackled for the smooth working of the business. These issues are as below.
01- Economic Order Quantity (EOQ):
Economic Order Quantity is the suitable quantity of inventory that is required to purchase and keeps in store. It is difficult to estimate as there are many factors that are involved in the calculation.
The most important thing in the inventory management is that it should be acquired before the final order of the customer.
02- Inventory Shortfall:
If the shortage of inventory occurred, then it would result in serious consequences, like disruption in the production process, and loss of the sale order of the customers etc.
03- Inventory Surplus:
In this case if the business acquires the excessive inventory, then there are also some disadvantages like wastage of inventory, increase in carrying cost depreciation etc.
04- Seasonal Sales:
During the seasonal sales, like Eid, Christmas, Dewali, etc there is high demand of products or services. If any sole proprietor of a trading business stocks an excessive inventory for the purpose of sale during the peak season by taking certain short term loan. Then he has to sell the entire inventory during the season otherwise after that period, he would have to sell it at a much cheaper rate, which further results in the loss. So he would finally become unable to pay the interest payments of the short term loan and this can cause bankruptcy.
Cost Associated with Inventory Management:
Following are a few important cost associated with the inventory.
- Carrying Cost:
It includes the following costs.
- Cost of Capital
- Storage (warehouse rent)
- Insurance Premium
- Wastage (ranges between 20 to 30% of the value of inventory)
- Shipping Cost:
It includes cost less than the 5% value of inventory.
- Cost of Keeping Minimum Inventory:
It includes the following costs.
- Loss of the sale order
- Loss of the specific customer permanently
- The goodwill of the business is affected
Inventory Management Policies:
Following are some of the effective inventory management policies that can be applied by the management of a business.
01- Latest Dynamic Systems:
With the development of the technology, the former static inventory software is replaced by the newest dynamic systems that keep not only the former inventory records, but also the trends of the sales growth and the future requirements of the inventory. MRP and ERP software are some of the examples of modern technology based systems.
02- Just-in-Time (JIT):
This is another effective inventory management policy that is being introduced by the Toyota Company of Japan. In JIT, the inventory is ordered and received just few hours before the due time of the sale order. In this way the company does not bear the headache and costs of maintaining sufficient inventory in the store, which results the increase in the overall efficiency of the company.
Outsourcing is another latest trend in the business world. Company itself does not manufacture the whole parts of its final products. It buys the parts from the other suppliers at a cheaper cost and avoids different issues of production. For example, the IT section of a software house company in America outsources their software programming to the professionals of the developing countries, like Pakistan, India, Bangladesh, and Philippine, etc.
03- Accounts Receivables (A/R) Management:
The third and important area of working capital management is the accounts receivables management. In today’s competitive world, the credit sales are essential element for the success of any business. These credit sales result in the creation of accounts receivables.
- Formula of Accounts Receivables (A/R):
Following is the formula for ascertaining the actual accounts receivables.
A/R = Daily Credit sales x Average collection period in days
For example, if the credit sale of $ 2000 each day is made for recovery time after 20 days. Then the actual accounts receivables becomes
A/R = 2000 (per day) x 20 (days)
A/R = $ 4000
A/C Receivable Management Policies
Certain factors are considered in granting credit to customers like,
- The creditworthiness of relevant customer is assessed before the credit sale.
- Less amount of credit should be given and the collection period should be kept low.
- The credit term should be creative.
01- Incentives For Customers:
The customers should be provided with certain incentives for the quicker recovery of debt. For example, “2/10.net 30 basis” is the term which shows that for the credit limit of 30 days, if the customers return the debt within 10 days then he will receive 2% discount. In this way the customers are stimulates to pays back quickly.
02- Penalty on Late Payments:
In this policy the business imposes the penalty charge on the customers, who pays back after the due date of credit. For example, if a customer owes the bill of $ 20,000 for the limit of 30 days. He fails to pay the debt within the due date. If the penalty rate is 1%, then the customers will have to pay the extra penalty charges of Rs 200 for every month till the repayment of the debt. In this way the customers are forced to pay debt on time.
Working Capital Financing Policies:
As working capital is quite different from the fixed assets, so it also requires some kind of financing. It is an important area in financial management as the working capital management or financing has serious affects on the success of any business.
Before going into the detail of the policies of working capital financing, let’s clear a simple concept of the assets.
Total Assets = Fixed Assets + Permanent Current Assets + Temporary Current Assets
The fixed assets of a healthy company increases gradually over the life of the company. On the other hand the temporary current assets do not remain in one direction, which means they fluctuate on the basis of the time.
Following are the three policies of the working capital financing that are based on the Maturity Matching Principle.
01- Aggressive Policy:
In this policy of working capital financing, short term loans are aggressively acquired for the purchase of most of current assets. All the temporary current assets are financed through short term loans. Even some portion of permanent current assets is also financed through the same sources.
The main advantage of this kind of financing is that the cost of capital is reduced as the shorter duration of a loan is; lower would be its interest rate. But this short term financing is risky as the renewal of the loan would not be confirmed on the same conditions.
02- Conservative Policy:
Conservative financing is opposite of the aggressive policy in such a way that the most of financing is made through long term loans. All the fixed assets together with the permanent current assets are acquired through long term loans. Even some portion of temporary current assets is also financed through the same sources.
The main benefit of using this policy is that long term financing is quite safe and less risky. But the interest rates of the long term loans are quite high, which results in the increase of cost of the capital acquired.
03- Moderate Policy:
Moderate policy serves as a balance between the short term and the short term financing. All the fixed and the permanent current assets are financed through the long term loans and the permanent current assets portion is financed through the short term loans. On the other hand the temporary current assets are financed through the spontaneous current liability.
Maturity Matching Principle:
It is the simple principle that the assets are financed according to their useful life. This means that the assets that have useful life of less than one year should be financed through the short term loans of less than a year. While the assets that has useful life of more than five years, should be financed through the long term loans of more than five years.
In general, companies prefer to adopt the moderate financing policy due to the reason of Maturity Matching Principle.
Following are the advantages of short term loans.
- The acquisition of the loans is speedy.
- There is flexibility of the money borrowed, which is not locked for a longer period.
- The interest rates are low, which results in lowering the cost of debt.
The major disadvantage of short term financing is that the debt cost is not certain, and hence in the long run it is variable, because it in non-renewable.