CONCEPT AND MANAGEMENT OF WORKING CAPITAL 






Introduction



Capital is something which is used for starting or expanding a business. It provides the firm with a pathway to grow and prevail in the competitive modern market.  In this regard, it is to be stated that the working capital is used by the businesses in order to meet the day to day expenses and due to this reason, it can be stated that the management of working capital is helpful in stabilising the liquidity position of a company. The aim of the article is to discuss and determine how working capital is important and the importance of managing the working capital. Here types of capital and types of working capital along with types of working capital management are considered to evaluate the importance of working capital management.


Capital required for a business can be classified into two broad categories –


a)                  Fixed Capital


b)                 Working Capital


Fixed Capital refers to the capital, which is invested in fixed assets such as property, plant & equipment (PP&E) – that are needed to start up and conduct business even at the initial stage.  These assets are fixed in the sense that they are not completely consumed during a particular financial year but also have some reusable value in future as well.


Working Capital is the measure of a company’s liquidity, operational efficiency and financial health. It provides a company with aid to grow and invest in short term basis which reflects its optimal financial management of capital. Working capital management refers to the management of purchase of raw material, paying of wages, cash management and various day-to-day and short term activities which are important to carry on the business efficiently and effectively.













Meaning of Working Capital Management



Working capital management basically involves optimal usage of current assets and current liabilities of a firm through which it can maintain its short-term operating costs and short-term debt obligations. It ensures the maintenance of sufficient cash flow. It takes in accounts various ratios like inventory turnover ratio, working capital ratio and collection ratio in order to evaluate or examine the working capital management. Working capital ratio, which is calculated by dividing current assets by current liabilities, helps to ascertain a company’s financial health. Generally working capital ratio of 1.2 to 2.0 indicates better financial health; whereas ratio greater than 2.0 indicates worsening of financial functions. However, it varies from industry to industry.





Need for Working Capital Management



Managing of working capital is a vital part of any business as it reflects the financial health of the firm. Thus, a financial manager always tries to maintain desirable working capital by which it can obtain its short term financial goals which reflect in the execution of long term financial achievements.


Some of the needs of working capital management are mentioned below-


●   A company needs to maintain a desirable working capital to meet its short term financial obligations. If it fails to do so then it leads to financial insolvency and potential bankruptcy.


●       By managing working capital efficiently, a company not only able to meet its obligations but also helps to obtain a boost in its earnings through maintaining favourable cash, accounts receivable turnover, inventory turnover and account payable turnover.


●  Managing working capitals means managing inventories, cash, accounts receivable and accounts payable. Thus it helps to identify any problem in the key operational areas which are directly involved with any firm’s profitability.


●  Potential investors verify the firm’s working capital management system with the help of various ratios (like liquidity ratios, turnover ratios and others) as it reflects the firm’s operational efficiency.








Components of Working Capital Management



The four major components of Working Capital Management are-


1.      Cash Management


2.      Accounts Receivables Management


3.      Inventory Management


4.      Accounts Payable Management











Cash Management



Cash is one of the main components of current assets as it involves obtaining raw materials and other direct expenses related to the production of final goods. Therefore, maintaining adequate cash is essential for a firm. A finance manager always keeps an eye on cash inflows and outflows to maintain adequate cash. When a business issues an invoice it is referred to as earnings though not yet received immediately. Keeping in mind the terms of invoice, 30, 60 & 90 days, a financial manager can manage its cash effectively. Whereas he/she also look out for accounts payable as it reflects cash outflows.


Accounts Receivables Management



            In the normal course of business, customers owed money to the firms as they purchase the goods on credit basis. It is one of the key components of working capital management. The total volume of accounts receivables depends upon the credit sale and debt collection policy. If a firm pushes its customers to pay for the credit very soon it may affect its potential sales whereas extending the credit period to customers helps to gain additional sales. Therefore it is important for a financial manager to examine the costs and benefits associated with it. (Aktas, Croci & Petmezas)





Financing Receivables= Receivables Balance * Interest (Overdraft) Due


Receivables Balance= Credit Sales*(receivables days/365)





Inventory Management 



Efficient management of inventories leads to maximisation of shareholders earnings as the firm does not hold too much or too less inventories. Pilling of inventories reflects reduce in sales or having too less inventories reflect the loss of potential sales.  The objective of the finance manager is to obtain raw materials for the production at an optimum rate and maintaining a smooth flow of raw materials from production and sales.


Accounts Payable Management



Payables provide a spontaneous source of working capital as it includes credit purchases, short term loans and advances and other short term obligations. Payable management is related to cash management as it indicates cash outflow from the business. Optimum payable management ensures a steady supply of material and also enhances its reputations.


Financing Payables= Payables Balance*Interest (Overdraft) Due


Payables balance= Credit Purchases*(Payables Days/365)








Limitations of Working Capital Management



Though it has lots of benefits, there are few limitations also which must be considered-


1.      Only Monetary Factors


2.      Non-Situational


3.      Based on Data


4.      Problem in Interpretation


Only monetary factors



Working capital management takes only monetary factors (like cash inflows and outflows) of a firm. Monetary factors like accounts receivables, cash and accounts payables are key components here. While the non-monetary factors like change in government policies, recessions and other factors are not taken into account.


Non-Situational



Another disadvantage of working capital management that it does not take into account the situational changes. It does not acknowledge the sudden changes in market conditions as it is based on past events and figures.


Based on Data



Working capital management operates on data only, like in case of trade receivables, it would require date of sales, the period of credit, a period of grace allowed, penalties to be applied in case of failure of payment. Thus in case, a single data gets absent it can give wrong results.


Problem in Interpretation



Working capital management involves various techniques of ratio analysis. Ratios are numbers which only allows the user to interpret the result. In most of the cases, the user does not know whether a particular outcome is favourable or not. Also, ratios vary on industry to an industry which makes it more difficult to use for the end users





Conclusions







Working capital management provides a firm with an effective tool to manage its capital effectively. It gives an insight to the user how the particular firm is performing against its peers. Though there are few drawbacks in the process still there are immense advantages which help to achieve a financial manager to secure the firm’s financial short term goals which result in achieving long term goals effectively. Strong working capital management system enhances the firm’s reputations in the market and help in creating a financial niche against its peers which in turn helps the firm to prevail in this modern competitive market.