Working Capital Management

What is Working Capital Management?

Working capital management involves managing a company's current assets minus current liabilities. Maintaining a certain amount of cash flow is important for short-term business goals, such as Debt and Operating Costs.

Now, the other associated term with WCM is the 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 maintained.

Types of working capital

There are two types:

A. 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. 

• Regular: This is the minimum amount required for regular expenses such as salaries, bills, etc
• 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. 

• Seasonal Variable: This is the additional capital needed during peak business seasons. Industries such as agriculture have specified seasons for raw material purchases
• Special Variable: Additional capital is needed if current assets must be invested to meet unexpected demands

B. Based on the concept

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

Factors Determining Working Capital

Some of the factors are stated below:

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 do not need cash or cash equivalents. As a result, there is little money invested in inventories or receivables.

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 raise labor and raw materials costs, raising the capital needed.

5. The volume of sales

The amount of capital and the sales turnover are impacted, and a strong negative relationship exists between them. 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

Some of the other methods include:

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 thrives 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. However, the firm will have to pay less for costs like labor if the production technology is capital-intensive. 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.

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.

Capital Management 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.

• Inventory: When we reduce liquidity, there are fewer stock-outs, increasing liquidity. As we keep increasing liquidity, the inventory is reduced, leading to a loss of goodwill and risk of stock-out. To find the optimum inventory level, we use EOQ, JIT, etc
• Receivables: In the case of receivables, a higher credit period is allotted to increase profitability (which attracts many customers). As we try to reduce the credit period, liquidity increases, but customers decrease. Hence, to find an optimum value, we evaluate credit policy and use debt management services
• 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
• Cash and Cash equivalents: Paying cash on time helps improve the chances of future discounts, similar to credit scores. However, delayed payments may offer other investment opportunities. For this, we can use cash budgets and other cash management techniques
• 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

Let's understand the investment and financing below:

• Nature of Industry: The type of industry determines the gestation period of the business. Based on the sector, capital investment is estimated
• Types of products: the size of inventory is decided depending on the type of product - durable or perishable
• Manufacturing vs. trading vs. service
• The volume of sales: High sales leads to high receivables
• Credit policy: the business might need more capital for raw materials and receivables depending on the credit policy of the company

Working Capital Management and Company Effectiveness

To determine the effectiveness of a company’s working capital, we need the three most essential components:

1. Accounts payable

2. Accounts receivable

3. 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.

2. Inventory Turnover Ratio

The formula to calculate is:

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 purchased merchandise, minus any items lost to damage or shrinkage, is a complete inventory turnover. Inventory turnovers frequently occur in successful businesses. However, the number varies by industry and product category.

3. Collection Ratio

The average amount of time that a company's trade accounts receivable are unpaid is known as the collection ratio. The collection ratio is calculated by dividing the total receivables by the average daily sales. 

An extended period during which receivables are outstanding increases the seller's credit risk and necessitates a higher working capital investment to pay for the underlying goods sold. 

However, a company may purposefully permit a protracted collection period 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. 

We can calculate the capital requirement for the year based on the estimated number of operating cycles. Some also use direct cost requirements for each current asset and current liability to estimate the requirements for the company.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Net Working Capital
• Shadow Inventory
• Taxation
• Underwriting
• Working Capital vs Investing Capital