Working Capital Management Importance, Determinants, Approaches

Table of Contents:-

  • Importance of Working Capital Management
  • Determinants of Working Capital Management Needs
  • Approaches to Manage Working Capital Management
  • Working Capital Management Under Inflation

Working capital management ensures the company has sufficient liquidity to meet its short-term obligations when they become due and carry out its usual day-to-day activities. There have been multiple examples where small businesses have failed due to a lack of liquidity despite increasing revenues.

Working Capital refers to a firm’s investment in short-term assets, including cash, short-term securities, accounts receivable (debtors), and inventories of raw materials, work-in-process, and finished goods. It can also be regarded as the portion of the firm’s total capital employed in short-term operations, encompassing all current assets and liabilities. In simpler terms, working capital is the investment necessary for carrying out the business’s day-to-day operations smoothly. The management of operating capital is equally important as the management of long-term financial investments.

Importance of Working Capital Management

Due to its close relationship with the day-to-day operations of a business, the study of working capital and its management holds significant importance for both internal and external analysts. It is increasingly recognized that inadequacy or mismanagement of operating capital is the primary cause of business failures. One must maintain that working capital management constitutes an integral part of overall financial management and ultimately, corporate management. Therefore, working capital management presents both a challenge and a welcome opportunity for a financial manager prepared to play a pivotal role in their organization.

Neglecting working capital management may lead to technical insolvency and even the liquidation of a business unit. As receivables and inventories tend to grow, coupled with the rising demand for bank credit due to stringent credit regulations in India by the Central Bank, managers need to cultivate a long-term perspective for effective working capital management. Inefficient working capital management can result in insufficient or excessive working capital, which poses significant risks.

A firm may encounter the following adverse consequences from inadequate working capital:

1. Stunted growth: The firm may need help undertaking profitable projects due to the unavailability of funds.

2. Implementation difficulties: Operating plans may become difficult to execute, hindering the firm’s profit goals.

3. Operating inefficiencies: Difficulties in meeting day-to-day commitments may lead to operational inefficiencies.

4. Underutilized fixed assets: Lack of working funds may prevent the efficient utilization of fixed assets, lowering the return rate on investments.

5. Missed credit opportunities: The need for more working capital may force the firm to forgo attractive credit opportunities.

6. Damage to reputation: The inability to honour short-term obligations results in losing the firm’s reputation, leading to tight credit terms.

On the other side, excessive working capital may give rise to the following risks:

1. Accumulation of Inventories: An excess of working capital may lead to the unnecessary accumulation of inventories, increasing the likelihood of mishandling, waste, and theft.

2. Liberal Credit Policy: It may provide an undue incentive for adopting an overly liberal credit policy and a lax approach to collecting receivables, resulting in a higher incidence of bad debts and adversely affecting profits.

3. Managerial Complacency: Excessive working capital may induce managerial complacency, eventually leading to inefficiency in management.

4. Speculative Practices: It may encourage the tendency to accumulate inventories for speculative profits, promoting a liberal dividend policy that becomes challenging to maintain when the firm cannot realize speculative profits. Therefore, enlightened management should consistently maintain an appropriate level of working capital. Financial and statistical techniques can be instrumental in predicting the required amount of operating capital at different times.

Determinants of Working Capital Management Needs

There are no set rules or formulas to determine the working capital requirements of a firm. Corporate management must consider numerous factors to ascertain the appropriate level of working capital. The amount of operating capital required by a firm is influenced not only by factors intrinsic to the firm itself but also by economic, monetary, and general business conditions.

Among the various factors, the following are deemed necessary:

  • Nature and Size of Business
  • Manufacturing Cycle
  • Business Fluctuations
  • Production Policy
  • Turnover of Circulating Capital
  • Credit Terms
  • Growth and Expansion Activities
  • Operating Efficiency
  • Price Level Changes
  • Other Factors

Nature and Size of Business

The nature of its business primarily influences the working capital requirements of a firm. Trading and financial firms generally have a low investment in fixed assets but require a substantial investment in working capital. For instance, retail stores must maintain large stocks of diverse merchandise to meet the varied demands of their customers. Similarly, certain manufacturing businesses, such as those in tobacco and construction, also need to invest significantly in working capital, with only a nominal amount allocated to fixed assets. In contrast, public utilities exhibit a limited need for working capital while making abundant investments in fixed assets. Their working capital requirements are nominal due to cash sales and the provision of services rather than products, resulting in either negligible or tiny amounts tied up with debtors or stocks. The working capital needs of most manufacturing concerns fall between the two extremes of trading firms and public utilities.

The size of a business also significantly impacts its working capital requirements, measured in terms of the scale of operations. A firm with a larger scale of operations will require more working capital than a smaller one. Additionally, the inherent hazards and contingencies associated with a specific type of business play a role in determining the magnitude of working capital, particularly in maintaining liquid resources.

Manufacturing Cycle

The manufacturing cycle commences with the procurement of raw materials and concludes with the production of finished goods. If the manufacturing cycle spans an extended period, the need for working capital increases because a prolonged manufacturing duration leads to a more extensive tie-up of funds in inventories. Any delays encountered at any stage of the manufacturing process result in work-in-process accumulation, thereby augmenting the requirement for working capital. Notably, companies producing heavy machinery or similar products, which involve a lengthy manufacturing cycle, endeavour to minimize their investment in inventories (and consequently in working capital) by securing advance or periodic customer payments.

Business Fluctuations

Seasonal and cyclical fluctuations in product demand significantly impact the working capital requirements, especially a firm’s temporary working capital needs. An upswing in the economy results in increased sales, leading to a rise in the firm’s investment in inventory and receivables or book debts. Conversely, an economic downturn may witness a decline in sales, reducing stock levels and outstanding debts. Seasonal fluctuations can also pose production challenges. Increasing production levels during peak periods may incur additional expenses. Some firms may opt for a consistent production policy to maximize resource utilization throughout all seasons. This approach results in inventory accumulation during off-seasons and rapid disposal during peak seasons. Therefore, advance financial arrangements for seasonal working capital requirements are essential. The financial plan should be flexible enough to accommodate any seasonal fluctuations.

Production Policy

If a firm adheres to a steady production policy, even in the face of seasonal demand, inventory will accumulate during off-season periods, leading to higher inventory costs and risks. When the expenses and risks associated with maintaining a constant production schedule are considerable, the firm may opt to vary its production schedule in response to changes in demand. Firms with versatile physical facilities capable of producing various products enjoy the advantage of diversified activities. Such companies have their main products during the season and alternate products during the off-season. Consequently, production policies may differ from one firm to another based on their specific circumstances. As a result, the need for working capital will also vary accordingly.

Turnover of Circulating Capital

The speed at which the operating cycle completes its round (i.e., cash → raw materials → finished product → accounts receivables → cash) plays a decisive role in influencing the working capital needs. 

Credit Terms

The firm’s credit policy impacts the size of working capital by influencing the level of book debts. While the credit terms granted to customers largely depend on the norms and practices of the industry or trade the firm belongs to, the firm can strive to shape its credit policy within such constraints. A prolonged collection period generally results in a more extensive tie-up of funds in book debts, and tax collection procedures may even elevate the risk of bad debts.

The working capital requirements of a firm are also influenced by the credit terms granted by its creditors. A firm benefiting from liberal credit terms will require less working capital.

Growth and Expansion Activities

As a company expands, a more significant amount of working capital logically becomes necessary. However, stating firm rules about the relationship between the growth in a firm’s business volume and its working capital needs takes time and effort. It is essential to recognize that the demand for increased working capital funds may precede the growth in business activities rather than follow it. The composition of working capital in a company may shift with changes in economic circumstances and corporate practices. Growing industries generally require more operating capital than static ones.

Operating Efficiency

Operating efficiency refers to the optimum use of resources. The company can minimize its need for working capital by efficiently controlling its operating expenses. Increased operating efficiency improves the use of working capital and accelerates the pace of the cash cycle. Better utilization of resources enhances profitability and alleviates the pressure on working capital.

Price Level Changes

A rising price level generally necessitates a higher investment in working capital. With increasing prices, the same levels of current assets require enhanced investment. However, firms that can promptly revise the prices of their products upward may avoid severe working capital problems during periods of rising levels. However, the effects of an increasing price level may be felt differently by different firms due to variations in individual prices. The rising prices may not affect some companies but may significantly impact others.

Other Factors

Several other factors influence the determination of the need for working capital. A high net profit margin contributes to the working capital pool. Net profit is a source of performing capital to the extent that it has been earned in cash. The cash inflow can be calculated by adjusting non-cash items such as outstanding expenses, depreciation, losses written off, etc., from the net profit.

The firm’s appropriation policy, specifically the decision to retain or distribute profits, also impacts working capital. The payment of dividends consumes cash resources, thereby reducing the firm’s operating capital to that extent. The firm’s working capital position will be strengthened if profits are retained.

In general, working capital needs also depend on the state of transport and communication infrastructure. If these aspects are underdeveloped, industries may be compelled to maintain substantial stocks of raw materials, spares, finished goods, etc., both at production sites and distribution outlets.

Approaches to Manage Working Capital Management

Two approaches are commonly followed for the management of working capital:

  1. The conventional approach, and
  2. The operating cycle approach.

The Conventional Approach

This approach implies efficiently and economically managing the individual components of working capital (i.e., inventory, receivables, payables, etc.) to ensure idle and sufficient funds. Techniques have been developed for managing each of these components. In India, more emphasis is placed on managing debtors because they typically constitute the largest share of the investment in working capital. On the other hand, inventory control has yet to be widely practised, possibly due to the scarcity of goods (or commodities) and constantly rising prices.

The Operating Cycle Approach

This approach considers working capital as a function of the volume of operating expenses. Under this approach, working capital is determined by the duration of the operating cycle and the operating expenses needed to complete the cycle. The active cycle duration involves the number of days in various stages, starting from acquiring raw materials to realising proceeds from debtors. The credit period allowed by creditors is considered in this process. The optimum level of working capital is the requirement of operating expenses for an operating cycle, calculated based on the operating expenses required for a year. In India, most organisations followed the conventional approach earlier, but the trend is shifting in favour of the operating cycle approach. Banks usually apply this approach when granting credit facilities to their clients.

Working Capital Management Under Inflation

It is advisable to address the increasing demand for capital to maintain the existing activity level, and this control becomes even more significant during inflation. To manage working capital needs in periods of inflation, the following measures may be applied:

  1. Discipline on the Production Front
  2. Scrutiny of Managed Costs
  3. Reducing Operating Cycle Span
  4. Clear Policy for Slow-Moving and Obsolete Stocks
  5. Timely Payment to Creditors

1. Discipline on the Production Front

a) Explore the possibility of using substitute raw materials without compromising quality. Undertake research activities in this regard with financial assistance from the Government and the corporate sector, if available.

b) Strive to increase workforce productivity through proper motivational strategies. Before implementing any incentive scheme, evaluate the costs against the expected benefits. Although wages are considered variable costs in accounting, they have become partly fixed due to legislative measures and increased productivity results in higher value-added, effectively reducing labour costs per unit.

2. Scrutiny of Managed Costs

Properly scrutinize managed costs, including office decorating expenses, advertising, managerial salaries, and payments. These costs are more or less fixed, making retreat difficult once committed. To minimize their impact, maximize the use of existing facilities and exercise caution in approving new expenditures.

3. Reducing Operating Cycle Span

To counter the increasing pressure on working capital, efforts should be made to reduce the span of the operating cycle. Increasing turnover with shorter intervals and quicker realization of debtors can significantly ease the situation.

4. Clear Policy for Slow-Moving and Obsolete Stocks

Develop and adhere to a clear-cut policy to dispose of slow-moving and obsolete stocks. Implement an efficient management information system that reflects the stock position from various standpoints.

5. Timely Payment to Creditors

Timely payments to creditors contribute to building a good reputation, enhancing the firm’s bargaining power regarding credit periods and other conditions. Projections of cash flows should be made to ensure that cash inflows and outflows align. If mismatches occur, consider postponing some payments or deferring the purchase of avoidable items.



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