Working Capital Management
It is the current assets of the company minus current liabilities
Working capital management is the current assets of the company minus current liabilities. WCM is important to maintain a certain amount of cash flow for short-term business goals - Debt and Operating Costs.
Now, the other associated term with WCM is Working Capital Cycle. It is the period a business takes to convert its current assets and liabilities into cash. The formula for calculating the Cycle period is as follows:
Cycle Period = Inventory days + Receivable Days - Payable Days
Let us understand the importance of WCM. A company needs cash flow to run its business operations, buy raw materials, and meet debt obligations.
Capital helps fulfill these needs. Hence efficiently managing it improves the company's earnings and helps run the business smoothly.
This also focuses on specific areas of the company where more profit could be generated, or liquidity can be maintained.
Types of working capital
There are two types:
Based on periodicity
Based on the concept
On the basis of periodicity
The requirement for capital may vary with the business activity. Based on periodicity, it is divided into the following two categories - permanent and variable working capital:
1. Permanent:
It is also known as Fixed Working Capital. As the term suggests, it is required for running the business smoothly. It is the minimum amount of current assets required for business activities in a year.
a. Regular: This is the minimum amount required for regular expenses such as salaries, bills, etc.
b. Reserve Margin: This is the necessary additional finance for tackling negative contingencies in the future.
2. Variable:
Variable working capital is also known as Fluctuating Capital. As the term suggests, these vary based on external factors such as the business cycle.
a. Seasonal Variable: This is the additional capital needed during the time of peak business seasons. Industries such as agriculture have specified seasons for raw material purchases.
b. Special Variable: Additional capital is needed if there is a need to invest in current assets to meet unexpected demands.
Based on the concept, it can be divided into two parts - gross and net working capital:
Gross: This is the total amount of capital invested in current assets.
Net: It is equivalent to current assets minus current liabilities.
Important factors determining working capital
1. Nature of companies:
The amount a company needs mostly depends on the nature of its industry.
Because they only accept cash payments and provide services rather than products, public utility companies like Electricity, Water Supply, and Railways have little need for cash or cash equivalents.
As a result, there is little money invested in inventories or receivables.
Contrarily, trade and financial organizations must invest significantly more in current assets such as cash, receivables, and inventory than fixed assets, necessitating a significant amount of capital.
2. Cash requirements:
Cash requirements vary from industry to industry, and as the cash requirements vary for current assets and liabilities, we can see changes in the capital requirement.
3. Nature and size of business:
The size of a company's operations, which can be quantified in terms of scale, directly impacts how much capital it needs. The need for cash will often increase with a company unit's size.
Occasionally, however, a smaller business may require more capital because of high administrative costs, ineffective resource utilization, and other small business economic disadvantages.
4. Time:
Where are we in the economic cycle? A price increase will result in higher labor and raw commodities costs, which will raise the amount of capital needed.
5. The volume of sales:
The amount of capital and the sales turnover are impacted and have a strong negative relationship. A company with a high stock turnover rate will require less than a company with a low turnover rate.
6. Terms of purchases and sales/demand of creditors:
A company's credit policy significantly influences the need for working capital in its interactions with debtors and creditors. A company needs less capital if it acquires its inputs on credit and sells its goods and services in cash.
On the other hand, a company that purchases its cash needs and offers credit to its customers would need a larger quantity of cash for current assets and liabilities.
This is because a significant share of its funds will inevitably be locked up in debtors or accounts receivable.
Other ways of determining working capital
1. Business Cycle:
The term "business cycle" describes all commercial activity's alternating expansion and contraction.
There is a greater need for working capital during a boom or when a business is thriving due to increased sales, pricing, optimistic growth, etc.
On the other hand, during a depression, a downturn in the cycle, businesses contract or sales drop, debtor collections are difficult to manage, and businesses may have a lot of capital sitting idle.
2. Production Technology and Cycle:
The unit will require greater working capital when using labor-intensive technology because it will need a larger sum to cover wages. The firm will have to pay less for costs like labor if the production technology is capital-intensive, though.
Therefore, businesses will need less of it.
3. Liquidity and Profitability:
The amount of working capital needed can change depending on price level changes. In general, rising prices will force the company to have more working capital because it will cost more to maintain the same current assets.
For various businesses, price increases may have different effects. The increase in costs may significantly impact certain businesses while having little or no impact on others.
4. Seasonal Fluctuations:
Some sectors experience seasonal shortages of raw materials. To ensure a constant supply, they must purchase raw materials in large quantities during the season and process them all year.
As a result, during such a season, a considerable amount is blocked in the form of material inventories, increasing the need for working capital. A firm often needs more working capital during the busy season than during the lean season.
Management of capital for current assets and current liabilities
Its scope of management can be divided into two parts:
1. Liquidity and Profitability
Each asset/capital has a tied cost to it. It is crucial to take care of liquidity, so we need to consider the cost linked to each capital. There is a trade-off between profitability and liquidity.
There are various techniques to find an optimum point. Let us have a look at those techniques.
a. Inventory
When we reduce the liquidity, there are fewer stock-outs; hence there is an increase in liquidity. As we keep increasing the liquidity, the inventory is reduced, leading to a loss of goodwill and risk stock-out.
To find the optimum inventory level, we use EOQ, JIT, etc.
b. Receivables
In the case of receivables, in order to increase profitability higher credit period is allotted (which attracts many customers).
As we try to reduce the credit period, the liquidity increases, but customers decrease. Hence, to find an optimum value, we evaluate credit policy and use debt management services.
c. Prepayment of expenses
This method leads to immunization against inflation, however, if we stop this, we will have higher liquidity. To find the optimum level, we use Cost-benefit analysis.
d. Cash and Cash equivalents
Paying cash on time helps improve the chances of future discounts, similar to credit scores.
However, on the other extreme, we have the possibility of other investment opportunities from delayed payments. For this, we can use cash budgets and other cash management techniques.
e. Payables and Expenses
Similar to Cash and Cash equivalents, payables and expense decisions dangle between investment opportunities or future discounts. For this, we evaluate credit policy and related costs.
2. Investment and Financing
a. Nature of Industry: The type of industry determines the gestation period of the business. Based on the sector, capital investment is estimated.
b. Types of products: the size of inventory is decided depending on the type of product - durable or perishable
c. Manufacturing vs. trading vs. service
d. The volume of sales: High sales leads to high receivables
e. Credit policy: the business might need more capital for raw materials and receivables depending on the credit policy of the company
How to evaluate a company's liquidity position?
Liquidity is a term used to evaluate a company's creditworthiness. The company's liquidity items are Cash, Marketable securities, accounts receivables, and inventory.
Liquidity ratios are used to measure a company's liquidity.
Evaluating the effectiveness of the company using Working Capital Management
To determine the effectiveness of a company's working capital, we need the three most essential components:
Accounts receivable
Inventory levels
Hence, there are various ratios to determine this efficiency. Let us have a look at these ratios below:
1. Working Capital ratio
Working Capital Ratio = Current Assets/Current Liabilities.
Sometimes, companies of different scales may have similar working capital, which doesn't necessarily mean the same financial health for both companies. Hence we have this ratio for comparison.
The higher this ratio is, the more cash on hand.
Current Assets:
a. Raw Material Inventory
Raw Materials Inventory Cost = Estimated Production * Estimated Cost per unit*Average Raw material storage period
b. Work-in-Progress Inventory
Work-in-Progress (WIP) Inventory Cost = Estimated Production * Estimated WIP cost per unit*Average WIP holding period
c. Finished Goods
Finished Goods Cost = Estimated Production * Estimated cost of production per unit*Average finished goods storage period
d. Receivables
Receivables Cost = Estimated Credit Sales * Estimated cost of sales per unit*Average receivable collection period
e. Cash and Cash Equivalents
Current Liabilities:
a. Trade Payables
Trade Payables = Estimated Credit Purchase * Credit period allowed by suppliers
b. Direct Wages
Direct Wages = Estimated labor hours * Wages rate per hour * Average time lag in payment of wages
c. Overheads
Overheads = Estimated Overheads * Average time lag in payment of overheads
Inventory Turnover Ratio = (Average Inventory/Cost of Goods Sold) * 365
Where,
Average Inventory = (beginning Inventory + Ending Inventory)/2
COGS is the direct cost involved in producing goods to be sold.
Inventory turnover is when a corporation purchases a product and sells it.
Having sold all of the merchandise that was purchased, minus any items lost to damage or shrinkage, is referred to as a complete turnover of inventory.
Inventory turnovers frequently occur in successful businesses. However, the number varies by industry and product category.
While high-end luxury items, such as luxury handbags, typically see few units sold yearly and lengthy production schedules, consumer packaged goods (CPG) typically have rapid turnover.
3. Collection ratio
The average amount of time that a company's trade accounts receivable are unpaid is known as the collection ratio. Total receivables divided by average daily sales are the calculation for the collection ratio.
An extended amount of time during which receivables are outstanding increases the seller's credit risk and necessitate a higher working capital investment in order to pay for the underlying goods that were sold.
However, a company may purposefully permit a protracted collection period in order to serve consumers with higher credit risk, whom its rivals will not sell to.
It can also be calculated based on the Operating Cycle, where the Net Operating Cycle consists of the Raw Material storage period, Work-in-progress holding period, Finished Goods storage period, Receivables collection period, and Credit period allowed by creditors.
Based on the number of operating cycles estimated we can calculate the capital requirement for the year. Some also use direct cost requirements for each current asset and current liability to estimate the requirements for the company.
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Researched and Authored by Punit Manjani | Linkedin
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