What Is Working Capital Management?

Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to the best effect. The
primary purpose of working capital management is to enable the company to maintain sufficient
cash flow to meet its short-term operating costs and short-term debt obligations.

A company's working capital is made up of its current assets minus its current liabilities.

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Working Capital

Understanding Working Capital Management

Current assets include anything that can be easily converted into cash within 12 months. These
are the company's highly liquid assets. Some current assets include cash, accounts receivable,
inventory, and short-term investments.

KEY TAKEAWAYS

 Working Capital Management requires monitoring a company's assets and liabilities to

maintain sufficient cash flow.
 The strategy involves tracking three ratios: the working capital ratio, the collection ratio,
and the inventory ratio.
 Keeping those three ratios at optimal levels ensures efficient working capital
management.
Current liabilities are any obligations due within the following 12 months. These include
operating expenses and long-term debt payments.

Ratio Analysis
Working capital management commonly involves monitoring cash flow, current assets, and
current liabilities through ratio analysis of the key elements of operating expenses, including the
working capital ratio, collection ratio, and inventory turnover ratio.

Working capital management helps maintain the smooth operation of the net operating cycle,
also known as the cash conversion cycle (CCC)—the minimum amount of time required to
convert net current assets and liabilities into cash.

Benefits of Working Capital Management

Working capital management can improve a company's earnings and profitability through
efficient use of its resources. Management of working capital includes inventory management as
well as management of accounts receivables and accounts payables.
The objectives of working capital management, in addition to ensuring that the company has
enough cash to cover its expenses and debt, are minimizing the cost of money spent on working
capital, and maximizing the return on asset investments.

Types of Working Capital Management Ratios

There are three ratios that are important in working capital management: The working capital
ratio or current ratio; the collection ratio, and the inventory turnover ratio.

Working capital management aims at more efficient use of a company's resources.

The working capital ratio or current ratio is calculated as current assets divided by current
liabilities. It is a key indicator of a company's financial health as it demonstrates its ability to
meet its short-term financial obligations.

Although numbers vary by industry, a working capital ratio below 1.0 generally indicates that a
company is having trouble meeting its short-term obligations. That is, the company's debts due in
the upcoming year would not be covered by its liquid assets. In this case, the company may have
to resort to selling off assets, securing long-term debt, or using other financing options to cover
its short-term debt obligations.

Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may
suggest that the company is not effectively using its assets to increase revenues. A high ratio may
indicate that the company is not securing financing appropriately or managing its working capital
efficiently.

The Collection Ratio

The collection ratio is a measure of how efficiently a company manages its accounts receivables.
The collection ratio is calculated as the product of the number of days in an accounting period
multiplied by the average amount of outstanding accounts receivables divided by the total
amount of net credit sales during the accounting period.

The collection ratio calculation provides the average number of days it takes a company to
receive payment after a sales transaction on credit. If a company's billing department is effective
at collections attempts and customers pay their bills on time, the collection ratio will be lower.
The lower a company's collection ratio, the more efficient its cash flow.

The Inventory Turnover Ratio

The final element of working capital management is inventory management. To operate with
maximum efficiency and maintain a comfortably high level of working capital, a company must
keep sufficient inventory on hand to meet customers' needs while avoiding unnecessary
inventory that ties up working capital.

Companies typically measure how efficiently that balance is maintained by monitoring the
inventory turnover ratio. The inventory turnover ratio, calculated as revenues divided by
inventory cost, reveals how rapidly a company's inventory is being sold and replenished. A
relatively low ratio compared to industry peers indicates inventory levels are excessively high,
while a relatively high ratio may indicate inadequate inventory levels.

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What is Working Capital Management?

Traditionally, investors, creditors and bankers have considered working capital as a critical
element to watch, as important as the financial position portrayed in the balance sheet and the
profitability shown in the income statement. Working capital is a measure of the company’s
efficiency and short term financial health. It refers to that part of the company’s capital, which is
required for financing short-term or current assets such a cash marketable securities, debtors and
inventories. It is a company’s surplus of current assets over current liabilities, which measures
the extent to which it can finance any increase in turnover from other fund sources. Funds thus,
invested in current assets keep revolving and are constantly converted into cash and this cash
flow is again used in exchange for other current assets. That is why working capital is also
known as revolving or circulating capital or short-term capital.
Formula for Working Capital: “Current Assets – Current Liabilities”
Net working capital is defined as the excess of current assets over current liabilities. Working
capital mentioned in the balance sheet is an indication of the company’s current solvency in
repaying its creditors. That is why when companies indicate shortage of working capital they in
fact imply scarcity of cash resources.

Factors effecting working capital:

• Nature of business: generally working capital is higher in manufacturing compared to service

based organizations
• Volume of sales: higher the sale, higher the working capital required
• Seasonality: peak seasons for sales need more working capital
• Length of operating and cash cycle: longer the operating and cash cycle, more is the
requirement of working capital

Working capital Approaches:

A) Matching or hedging approach: This approach matches assets and liabilities to maturities.
Basically, a company uses long term sources to finance fixed assets and permanent current assets
and short term financing to finance temporary current assets.
Example: A fixed asset which is expected to provide cash flow for 5 years should be financed
by approx 5 years long-term debts. Assuming the company needs to have additional inventories
for 2 months, it will then seek short term 2 months bank credit to match it.
B) Conservative approach: it is conservative because the company prefers to have more cash
on hand. That is why, fixed and part of current assets are financed by long-term or permanent
funds. As permanent or long-term sources are more expensive, this leads to “lower risk lower
return”.
C) Aggressive approach: The Company wants to take high risk where short term funds are used
to a very high degree to finance current and even fixed assets.

Classification of Working Capital:

Working capital can be categorized on basis of Concept (gross working capital and net working
capital) and basis of time (Permanent/ fixed WC and temporary/variable WC). The two major
components of Working Capital are Current Assets and Current Liabilities. One of the major
aspects of an effective working capital management is to have regular analysis of the company’s
currents assets and liabilities. This helps to take into account unforeseen events such as changes
in the market conditions and competitor activities. Furthermore, steps taken to increase sales
income and collecting accounts receivable also improves a company’s working capital.
Working Capital in adequate amount:

For every business entity adequate amount of working capital is required to run the operations. It
needs to be seen that there is neither excess nor shortage of working capital. Both excess, as well
as a shortage of working capital situations, are bad for any business. However, out of the two,
inadequacy or shortage of working capital is more dangerous from the point of view of the
company operations. Inadequate working capital has its disadvantages where the company is not
capable to pay off its short term liabilities in time, difficulty in exploring favorable market
situations, day to day liquidity worsens and ROA and ROI fall sharply. On the other hand, one
should keep in mind that excess of working capital also leads to wrong indications like idle
funds, poor ROI, unnecessary purchase and accumulation of inventories over required level due
to low rate of return on investments, all of which leads to fall in the market value of shares and
credit worthiness of the company.

Working capital cycle:

The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and
current liabilities into cash. The longer the cycle is, the longer a business is tying-up funds in its
working capital without earning any return on it. This is also one of the essential parameters to
be recorded in working capital management.

Working Capital Management:

Working Capital Management (WCM) refers to all the strategies adopted by the company to
manage the relationship between its short term assets and short term liabilities with the objective
to ensure that it continues with its operations and meet its debt obligations when they fall due. In
other words, it refers to all aspects of administration of current assets and current liabilities.
Efficient management of working capital is a fundamental part of the overall corporate strategy.
The WC policies of different companies have an impact on the profitability, liquidity and
structural health of the organization. Although investing in good long-term capital projects
receives more emphasis than the day-to-day work associated with managing working capital,
companies that do not handle this financial aspect (working capital) well will not attract the
capital necessary to fund those highly visible ventures; in other words, you must get through the
short run to get to the long run.

Components associated with WCM:

Often the interrelationships among the working capital components create real challenges for the
financial managers. Inventory is purchased from suppliers, sale of which generates accounts
receivable and collected in cash from customers to pay off those suppliers. Working capital has
to be managed because the firm cannot always control how quickly the customers will buy, and
once they have made purchases, exactly when they will pay. That is why; controlling the “cash-
to-cash” cycle is paramount.
The different components of working capital management of any organization are:
• Cash and Cash equivalents
• Inventory
• Debtors / accounts receivables
• Creditors / accounts payable

A) Cash and Cash equivalents:

One of the most important working capital components to be managed by all organizations is
cash and cash equivalents. Cash management helps in determining the optimal size of the firm’s
liquid asset balance. It indicates the appropriate types and amounts of short-term investments
along with efficient ways of controlling collection and payout of cash. Good cash management
implies the co-relation between maintaining adequate liquidity with minimum cash in bank. All
companies strongly emphasize cash management as it is the key to maintain the firm’s credit
rating, minimize interest cost and avoid insolvency.

B) Management of inventories:

Inventories include raw material, WIP (work in progress) and finished goods. Where excessive
stocks can place a heavy burden on the cash resources of a business, insufficient stocks can result
in reduced sales, delays for customers etc. Inventory management involves the control of assets
that are produced to be sold in the normal course of business.

For better stock/inventory control:

o Regularly review the effectiveness of existing purchase and inventory systems

o Keep a track of stocks for all major items of inventory
o Slow moving stock needs to be disposed as it becomes difficult to sell if kept for long
o Outsourcing should also be a part of the strategy where part of the production can be done
through another manufacturer
o A close check needs to be kept on the security procedures as well

C) Management of receivables:

Receivables contribute to a significant portion of the current assets. For investments into
receivables, there are certain costs (opportunity cost and time value) that any company has to
bear, alongwith the risk of bad debts associated to it. It is, therefore necessary to have proper
control and management of receivables which helps in taking sound investment decisions in
debtors. Thereby, for effective receivables management one needs to have control of the credits
and make sure clear credit practices are a part of the company policy, which is adopted by all
others associated with the organization. One has to be vigilant enough when accepting new
accounts, especially larger ones. Thereby, the principle lies in establishing appropriate credit
limits for every customer and stick to them.

Effectively managing accounts receivables:

o Process and maintain records efficiently by regularly coordinating and communicating with
credit managers’ and treasury in-charges
o Prepare performance measurement reports
o Control accuracy and security of accounts receivable records.
o Captive finance subsidiary can be used to centralize accounts receivable functions and provide
financing for company’s sales

D) Management of accounts payable:

Creditors are a vital part of effective cash management and have to be managed carefully to
enhance the cash position of the business. One has to keep in mind that purchasing initiates cash
outflows and an undefined purchasing function can create liquidity problems for the company.
The trade credit terms are to be defined by companies as they vary across industries and also
among companies.

Factors to consider:

o Trade credit and the cost of alternative forms of short-term financing are to be defined
o The disbursement float which is the amount paid but not credited to the payers account needs
to be controlled
o Inventory management system should be in place
o Appropriate methods need to be adopted for customer-to-business payment through e-
commerce
o Company has to centralize the financial function with regards to the number, size and location
of vendors

Time and money concept in Working Capital:

Every component of working capital (namely inventory, receivables and payables) has two
dimensions TIME and MONEY, in managing working capital. By making the money move
faster around the cycle, one can reduce the amount of money tied up. This helps the business
generate more cash or it will need to borrow less money to fund its working capital.
Consequently, it would either reduce the cost of interest or have free funds to support additional
sales growth or investments of the company. Similarly, if one can negotiate on better terms with
suppliers i.e. get an increased credit limit or longer credit; it will effectively create additional
cash to help fund future sales.

Hence to conclude, Working capital in lay men terms can be compared to the blood vessels in
any human body which makes the body function properly and thus make maximum utilization of
the human or company assets.

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Meaning and Concept of Working Capital:
Working Capital refers to a firm’s investment in short
term assets-cash, short term securities, accounts
receivable and inventories. Net Working Capital is
defined as current assets minus current liabilities.
Working Capital management refers to all aspects of the
administration of both current assets and current
liabilities.
Working capital is needed in any business because of the
time lag between paying for materials and operating
costs, and getting the money back again (together with
added profit) from the customer.
Working capital means current assets. Current assets means assets which can be converted into cash
within an accounting year and includes cash, short term securities, bills receivable, stock etc. Gross
working capital refers to the firm’s total investment in current assets.

Net working capital = current assets – current liabilities. The term working capital is commonly used for
the capital which is required for day-to-day working in a business concern, such as for purchasing raw
material, for meeting day-to-day expenditure on employee salaries, wages, rents, advertising etc.

Classification of Working Capital:

Working capital may be classified as follows:

(1) On the basis of concept Working capital may

be classified as:
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(i) Gross working capital.

(ii) Net working capital.

These terms have been discussed above.

(2) On the basis of periodicity of requirement:

(i) Permanent (or Fixed) Working Capital:

This capital is permanently locked up in the current assets to carry out the business smoothly. This
investment in current assets is of the permanent nature and will increase as the size of business
expands.

Permanent working capital is that minimum amount of investment in raw materials, work-in-process
inventory, finished goods, stores and spares, accounts receivable and cash balance which a firm is
required to have in order to carry on a desirable level of business activity.

Such an amount cannot be reduced if the firm wants to carry on the business operations without
interruption. It is that minimum amount which is absolutely essential throughout the year on a
continuous basis for maintaining the circulation of current assets.

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Minimum cash is required for making payment of wages, salaries, and other expenses; minimum stock is
required to maintain regular supplies and minimum investment in debtors is essential on account of
credit sales according to the period of credit allowed to the customers. Since the requirement of
permanent or hard core working capital is on a permanent basis, such working capital should be
financed out of long-term funds.

Characteristics of permanent working capital:

(1) The size of permanent working capital grows with the growth of business.

(2) It keeps on changing its form from one current asset to another.

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(3) As long as the firm is a going concern, working capital cannot be substantially reduced.

(a) Regular Working Capital:

It is the minimum amount of liquid capital needed to keep up the circulation of the capital from cash to
inventories, to receivable and again to cash. This would include sufficient minimum bank balance to
discount all bills, maintain adequate supply of raw materials etc.

(b) Reserve Margin or Cushion Working Capital:

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It is the excess over the needs or regular working capital that should be kept in reserve for contingencies
that may arise at any time. These contingencies include rising prices, strikes, special operations such as
experiments with new products etc.

(ii) Variable Working Capital:

Variable working capital requires changes with the increase or decrease in the volume of production or
business.

Variable working capital can be classified as:

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(a) Seasonal Working Capital:

The working capital required to meet the seasonal needs of the industry or business is known as
seasonal working capital. For example, if an enterprise is marketing woolen garments, it needs more
money for that purpose during winter months than in summer season. Similar is the case with a
factory/business engaged in the production or marketing or coolers, refrigerators or air-conditioners.
They are all Seasonal products.

(b) Special Working Capital:

Special working capital is that part of the variable working capital which is meant for meeting the special
business operations such as extensive marketing campaigns, experiments with products or methods of
production, etc.

The distinction between fixed and variable working capital is of great significance particularly in raising
the funds for an enterprise. Fixed working capital should be raised in the same way as fixed capital is
procured. Variable working capital is procured out of short-term borrowings from the bank or from the
public.

Factors Affecting Requirements for Working Capital:

In addition to the investment in a fixed asset, it is sometimes necessary to carry additional cash,
receivables or inventories. This investment in working capital is treated as a cash outflow at the time it
occurs.

The working capital needs of a firm are influenced by the following factors:

(1) Nature of Business:

A machine tool manufacturing concern which has a long operating cycle and sells largely on credit has a
very substantial working capital requirement.
On the other hand a service firm, such as an electricity undertaking or a transport corporation with a
short operating cycle and sales predominantly on cash basis, has a modest working capital requirement.

(2) Seasonality of Operations:

A firm manufacturing seasonal products such as fans, coolers, woolen clothes etc., has a highly
fluctuating working capital requirement.

On the other hand, a firm manufacturing electric bulbs or tube-lights or televisions has fairly even sales
round the year and hence a stable working capital need.

(3) Conditions of Supply:

If the raw inventory required for production is easily available throughout the year, the firm can manage
with a small capital being involved in inventory. However, if the raw material supply is scant and
unpredictable, then, to ensure continuity of production, the firm has to keep a good stock of inventory
which will involve large working capital.

(4) Marketing Conditions:

If the market is strong and competition is weak, the firm can manage with smaller inventory of finished
goods as customers can be served after a delay. In this situation, the firm can insist on cash selling or
even can ask for advance payment. This will avoid lock up of funds in accounts receivable.

On the other hand, if many firms are making the same product (like T.V., Refrigerators, etc.) and the
competition is high, the firm has to keep a larger inventory of finished goods so that its product is not
out of stock at any time. In this situation, the working capital needs tend to be high.

Sources of Working Capital:

Funds from business operations.

(2) Other incomes such as from dividends, transfer fees, donations, interest from investments made in
other companies, etc.

(3) Sale of non-current assets such as useless and obsolete plant and machinery.

(4) Long-term borrowings.

(5) Issue of additional equity capital or preference share capital.

Uses of Working Capital:

1. Loss from business operations would decrease the working capital.

2. The purchase of non-current assets generally causes a decrease in current assets or increase in
current liabilities. Therefore, it should appear as the use of funds.

3. The retirement of long-term liabilities such as payment to preference shareholders and debenture
holders involves the use of cash.

4. Dividend to shareholders.

5. Interest to lenders.

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1. Gross Working Capital:

The concept of gross working capital refers to the total value of current assets. In other words,

gross working capital is the total amount available for financing of current assets. However, it

does not reveal the true financial position of an enterprise. How? A borrowing will increase

current assets and, thus, will increase gross working capital but, at the same time, it will increase

current liabilities also.

As a result, the net working capital will remain the same. This concept is usually supported by

the business community as it raises their assets (current) and is in their advantage to borrow the

funds from external sources such as banks and the financial institutions.

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In this sense, the working capital is a financial concept. As per this concept:
Gross Working Capital = Total Current Assets

2. Net Working Capital:

The net working capital is an accounting concept which represents the excess of current assets

over current liabilities. Current assets consist of items such as cash, bank balance, stock, debtors,

bills receivables, etc. and current liabilities include items such as bills payables, creditors, etc.

Excess of current assets over current liabilities, thus, indicates the liquid position of an

enterprise.

The ratio of 2:1 between current assets and current liabilities is considered as optimum or sound.

What this ratio implies is that the firm/ enterprise have sufficient liquidity to meet operating

expenses and current liabilities. It is important to mention that net working capital will not

increase with every increase in gross working capital. Importantly, net working capital will

increase only when there is increase in current assets without corresponding increase in current

liabilities.

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Thus, in the form of a simple formula:

Net Working Capital = Current Assets-Current Liabilities

After subtracting current liabilities from current assets what is left over is net working capital.

This process functions much like the following:

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Current Asset
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2. Net Working Capital:

The net working capital is an accounting concept which
represents the excess of current assets over current
liabilities. Current assets consist of items such as cash,
bank balance, stock, debtors, bills receivables, etc. and
current liabilities include items such as bills payables,
creditors, etc. Excess of current assets over current
liabilities, thus, indicates the liquid position of an
enterprise.

The ratio of 2:1 between current assets and current

liabilities is considered as optimum or sound. What this
ratio implies is that the firm/ enterprise have sufficient
liquidity to meet operating expenses and current
liabilities. It is important to mention that net working
capital will not increase with every increase in gross
working capital. Importantly, net working capital will
increase only when there is increase in current assets
without corresponding increase in current liabilities.

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Thus, in the form of a simple formula:

Net Working Capital = Current Assets-Current Liabilities
CURRENT RATIO = CURRENT ASSETS
--------------------------
CURRENT LIABILITIES
YEAR 2017

CURRENT ASSETS = cash in hand + cash at bank + bill receivables + debtors + stock

= 271908.54 + 9922.85 + 64820 + 1254815.00 + 604000 + 4175245.00

=6380171.92

CURRENT LIABILITIES = bank o/d + bills payables + creditors

= 2308730.96 + 808096.00 + 1278501.00 + 11000 + 8470 + 38898

=4423695.96

CURRENT RATIO = 6380171.92

---------------------- =1.44: 1
4423695.96