Introduction

Sound working Capital Management has become a necessity in an era of information technology
for a company to succeed. The best example to support this argument is the performance of Dell
computers as reported in one of the recent Fortune article.

A perusal of the article will give us an insight into how Dell could use technology for improving
the performance of components of working capital.

1. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and
dealers.

2. Outsourcing an operations if the firm’s core competence does not permit the performance of
the operation effectively.

3. Train the employees to accept change.

4. Introduction of internet business

5. Releasing Capital by reduction in investment in inventory for improving the profitability of

operating capital.

A financial manger spends a large part of his time in managing working capital.

There are two important elements of working capital management.

1. Decisions on the amount of current assets to be held by a firm for efficient operations of its
business.

2. Decisions on financing working capital requirement.

Inadequacy or mismanagement of Working Capital is the leading cause of many business

failures. Working Capital is that portion of asset of a business which are used in current
operations. They are used in the operating cycle of the firm. It is defined as the excess of Current
Assets over Current Liabilities and provisions.

Components of Current Assets and Current Liabilities

Current Assets are:

1) Inventories 2) Sundry Debtors 3) Bills Receivables 4) Cash and Bank Balances 5) Short term
investments 6) Advances such as advances for purchase of raw materials, components and
consumable stores, prepaid expenses etc.

Current Liabilities are:-

1) Sundry Creditors 2) Bills Payable 3) Creditors for outstanding expenses 4) Provision for tax 5)
Other provisions against the liabilities payable within a period of 12 months.

Working Capital Management is concerned with managing the different components of current
assets and current liabilities. A firm must have adequate Working Capital neither excess nor
shortage. Maintaining adequate Working Capital at the satisfactory level is crucial for
maintaining the competitiveness of a firm.

Any lapse of a firm on this account may lead a firm to the state of insolvency.

Concepts of Working Capital

There are two important concepts of Working Capital – gross and net

Gross Working Capital: Gross Working Capital refers to the amounts invested in the various
components of current assets. This concept has the following practical relevance.

a. Management of current assets is the crucial aspect of Working Capital Management.

b. It is an important component of operating capital. Therefore, for improving the profitability on

its investment a finance manager of a company must give top priority to efficient management of
current assets.

c. The need to plan and monitor the utilization of funds of a firm demands working capital
management as applied to current assets.

d. It helps in the fixation of various areas of financial responsibility.

Net Working Capital

Net Working Capital is the excess of current assets over current liabilities and provisions. Net
Working Capital is positive. when current assets exceed current liabilities and negative when
current liabilities exceed current assets. This concept has the following practical relevance.

1. It indicates the ability of the firm to effectively use the spontaneous finance in managing the
firm’s Working Capital requirements.

2. A firm’s short term solvency is measured through the net Working Capital position it
commands.

Permanent Working Capital

Permanent Working Capital is the minimum amount of investment required to be made in

current assets at all times to carry on the day to day operation of firm’s business. This minimum
level of current assets has been given the name of core current assets by the Tandon Committee.
It is also known as fixed Working Capital.
Temporary Working Capital

It is also known as Variable Working Capital or fluctuating Working Capital. The firm’s
working capital requirements vary depending upon the seasonal and cyclical changes in demand
for a firm’s products. The extra Working Capital required as per the changing production and
sales levels of a firm is known as Temporary Working Capital.

Objective of Working Capital Management

The basic objective of financial management is maximizing the net wealth of shareholders. A
firm must earn sufficient returns from its operations to ensure the realization of this objective.
There exists a positive correlation between sales and firm’s return on its investment. The amount
of earnings that a firm earns depends upon the volume of sales achieved. There is the need to
ensure adequate investment in current assets, keeping pace with accelerating sales volume. Firms
make sales on credit. There is always a time gap between sale of goods on credit and the
realization of proceeds of sales from the firm’s customers. Finance manger of a firm is required
to finance the operation during this time gap. Therefore, objective of Working Capital
Management is to ensure smooth functioning of the normal business operations of a firm. The
firm has to decide on the amount of Working Capital to be employed.

The firm may have a conservative policy of holding large quantum of current assets to ensure
larger market share and to prevent the competitors from snatching any market for their products.
But such a policy will affect the firm’s return on its investment. The firm will have higher than
the required amount of investment in current assets. This excess funds locked in current assets
will reduce the firm’s profitability on operating capital.

On the other hand a firm may have an aggressive policy of depending on spontaneous finance to
the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous
finance. Here a firm will try to reduce its investments in current assets as much as possible but
without affecting the firm’s ability to meet working capital needs for sales growth targets. Such a
policy will ensure higher return on its investment as the firm will not be locking in any excess
funds in current assets. However, any error in forecasting can affect the operations of the firm
unfavorably if the error is fraught with the down side risk. There is also another risk of firm
losing on maintaining its liquidity position.

Objective of working capital management is achieving a trade – off between liquidity and
profitability of operations for the smooth conduct of normal business operations of the firm.

Need for working Capital

The need for working capital arises on account of two reasons:

a. To finance operations during the time gap between sale of goods on credit and realization of
money from customers of the firm.

b. To finance investments in current assets for achieving the growth target in sales.
Therefore finance the operations in operating cycle of a firm working capital is required.

Determinants of Working Capital

A large number of factors influence Working Capital needs of a firm. The basic objective of a
firm’s Working Capital management is to ensure that the firm has adequate working capital for
its operations, neither too much not too little. Investing heavily in current assets will drain the
firm’s earnings and inadequate investment in current assets will reduce the firm’s credibility as it
affects the firm’s liquidity. Therefore, the need to strike a balance between liquidity and
profitability cannot be ignored. The following factors determine a firm’s working capital
requirements.

1. Nature of business: Working Capital requirements are basically influenced by the nature of
business of the firm. Trading organizations are forced to carry large stocks of finished goods,
accounts receivables and accounts payables. Public utilities require lesser investment in working
capital.

2. Size of Business Operation: Size is measured in terms of a scale of operation. A firm with
large scale of operation normally requires more Working Capital than a firm with a low scale of
operation.

3. Manufacturing Cycle: Capital intensive industries with longer manufacturing process will
have higher requirements of Working Capital because of the need to run their sophisticated and
long production process.

4. Products Policy: Production schedule of a firm influences the investments in inventories. A

firm, exposed to seasonal changes in demand when following a steady production policy will
have to face the costs and risks associated with inventory accumulation during the off-season
periods. On the other hand a firm with a variable production policy will be facing different
dimensions of management of working capital. Such a firm may have to effectively handle
problem of production planning and control associated with utilization of installed plant capacity
under conditions of varying volumes of production of products of seasonal demand.

5. Volume of sales: There is a positive direct correlation between the volume of sales and the
size of working capital of a firm.

6. Term of Purchase and Sales: A firm which allows liberal credit to its customers will need
more working capital than that of a firm with strict credit policy. A firm which enjoys liberal
credit facilities from its suppliers requires lower amount of working capital when compared to a
firm which does not have such a facility.

7. Operating efficiency: The firm with high efficiency in operation can bring down the total
investment in working capital to lower levels. Here effective utilization of resources helps the
firm in bringing down the investment in working capital.
8. Price level changes: Inflation affects the working capital levels in a firm. To maintain the
operating efficiency under an inflationary set up a firm should examine the maintenance of
working capital position under constant price level. The financial capital maintenance demands a
firm to maintain higher amount of working capital keeping pace with rising price levels. Under
inflationary conditions same levels of inventory will require increased investment. The ability of
a firm to revise its products prices with rising price levels will decide the additional investment
to be made to maintain the working capital intact.

9. Business Cycle: During boom, sales rise as business expands. Depression is marked by a
decline in sale. During boom, expansion of business can be achieved only by augmenting
investment in various assets that constitute working capital of a firm. When there a decline in
business on account of depression in economy, inventory glut forces a firm to maintain working
capital at a level far in excess of the requirements under normal conditions.

10. Processing technology: Longer the manufacturing cycle the larger the investment in working
capital. When raw material passes through several stages in the production process work in
process inventory will increase correspondingly.

11. Fluctuations in the supply of raw materials: Companies which use raw materials available
only from one or two sources are forced to maintain buffer stock of raw materials to meet the
requirements of uncertainty in lead time

Such firms normally carry more inventory than it would have, had the materials been available in
normal market conditions.

Estimation of Working Capital

The best approach to estimate is based on operating cycle. Therefore, the two components of
working capital are current assets and current liabilities. This approach is based on the
assumption that production and sales occur on a continuous basis and all costs occur accordingly.

Estimation of Current Assets.

1. Raw materials inventory: Average investment in raw material is estimated.

2. Average investment in work-in-progress inventory is estimated.

3. Average investment in finished goods inventory is estimated.

4. Average investment in receivables (i,e both in debtors and bills receivables) is estimated based
on credit policy that the firm wishes to pursue.

5. Based on the firm’s attitude towards risk, access to borrowing sources, past experience and
nature of business, firms decide on the policy of maintaining the minimum cash balances.

Estimation of Current Liabilities:

1. Trade Creditors: Based on production budget, raw material consumption, credit period
enjoyed from suppliers, average amount of financing available to the firm is estimated.

2. Direct wages: Based on production budget, direct labour cost per unit, average time-lag in
payment of wages, estimation is made on total wages to be paid on an average basis.

3. Overheads: Based on production budget, overhead cost per unit and average time-lag in
payment of overhead, an estimation on an average basis of the amount outstanding to be paid to
creditors for overhead is estimated.