Working Capital Management Notes

What is Working Capital

  • Definition: Working capital is the amount of money that a company has tied up in funding its day-to-day operations.
    • It funds stocks, credit sales, and other current assets.
    • Offset by current liabilities like purchases on credit.
    • In some industries, e.g., grocery retail, working capital can even be negative due to cash sales contributing to funding.

Working Capital Terminology

  • Gross Working Capital: Refers to current assets used in operations, according to financial analysts.
  • Net Working Capital: Dollar difference between current assets and current liabilities, often used in accounting contexts.
  • Net Operating Working Capital: Current assets minus non-interest bearing current liabilities.
  • Working Capital Policy: Decisions regarding the levels of current assets to hold and their financing methods.
  • Working Capital Management: Involves setting capital policies and their daily implementation, including controlling cash, inventories, A/R, and short-term liabilities.
    • Measures liquidity available to build the business.
    • Different industries have unique working capital profiles.

Types of Industries

  • Hypermarkets: High cash sales, minimal receivables.
  • Car Dealers: Hold finished goods inventory.
  • Manufacturers: Maintain stock of raw materials and WIP (Work In Progress).
  • FMCG (Fast Moving Consumer Goods): Products with limited shelf life, sold rapidly.
  • Large Corporations: Negotiate extended credit terms from suppliers.
  • Seasonal Businesses: Examples include travel agents and hotels.

Classification of Working Capital

  • By Components: Cash, marketable securities, receivables, inventory.
  • By Time:
    • Permanent Working Capital: Required to meet long-term needs. It changes in its components but maintains a consistent level of investment.
    • Temporary Working Capital: Fluctuates with seasonal or cyclical business variations, e.g., increasing stock during festive sales.

Objectives of Working Capital Management

  • Ensure sufficient liquid resources.
  • Minimize insolvency risk while maximizing return on assets.
  • Maintain optimum balance of each working capital component.

Classification of Current Assets

  • Permanent Current Assets: Required for long-term operations, e.g., minimum cash or stock levels.
  • Fluctuating Current Assets: Change with seasonal demands, e.g., retailers building stock before Christmas.

Working Capital Financing Policies

  • Aggressive Financing Policy:
    • Uses more short-term financing for current assets.
    • Higher risk due to fluctuating interest rates, but potential for higher returns.
  • Conservative Financing Policy:
    • Uses long-term financing for both permanent and temporary current assets.
    • Less risk with locked-in fixed rates for the life of the loan.
  • Moderate Financing Policy:
    • Balances short-term and long-term financing based on asset maturity.

Working Capital Cycle

  • The average time (in days) between paying for materials and receiving customer payments.
  • Formula:
    extWorkingCapitalCycle=extRawMaterialsHoldingPeriod+extWIPHoldingPeriod+extFinishedGoodsHoldingPeriod+extReceivablesCollectionPeriod−extPayablesPaymentPeriodext{Working Capital Cycle} = ext{Raw Materials Holding Period} + ext{WIP Holding Period} + ext{Finished Goods Holding Period} + ext{Receivables Collection Period} - ext{Payables Payment Period}
  • It is used to assess liquidity and efficiency in cash management.

Importance of Working Capital

  • Longer inventory turnover or debtors periods lead to more money tied up in working capital.
  • Maintaining a balanced operating cycle is essential for liquidity.
  • Ratio analysis can highlight areas needing better management of working capital.

Liquidity Ratios

  • Current Ratio: Ratio of current assets to current liabilities, indicating ability to pay debts.
    • Rule of Thumb: Should ideally be 2:1.
  • Acid Test Ratio (Quick Ratio): Ratio of liquid assets to current liabilities (excluding inventory).
    • Rule of Thumb: Should be 1.0 or higher.

Monitoring Working Capital Cycle

  • Comparing current cycle to previous cycles helps identify trends.
  • Longer cycles indicate a larger investment in inventory and receivables, potentially worsening cash flow.
  • Shorter cycles indicate improved cash flow.
  • Managers use cash budgets and liquidity ratios to manage cash flow effectively.

Over-Capitalisation and Over Trading

  • Over-Capitalisation: When working capital exceeds needs, leading to low ROI (Return on Investment). Examples:
    • High current ratios (> 2:1) & quick ratios (> 1:1).
  • Overtrading: Operating with insufficient capital, leading to severe finance problems.
    • Symptoms include increased sales and receivables, longer payment terms, and decreased ratios indicating pressure on liquidity.

Control Measures

  • Monitor orders to assess impact on capacity and capital needs.
  • Control purchase commitments to manage payables effectively.

Methods to Reduce Cash Operating Cycle

  • Improve stock turnover by optimizing purchasing.
  • Enhance production efficiency to reduce cycle time.
  • Strengthen credit terms with customers while extending with suppliers where possible.