Unit 5: Working Capital Management

Working Capital Management

Working Capital Management refers to the management of a company’s short-term assets and liabilities to ensure it has sufficient cash flow to carry out day-to-day operations.

🧾 Formula:

Concepts of Working Capital

1️⃣ Gross Working Capital

• Refers to total current assets of the business.
• Focuses on investment in current assets.

2️⃣ Net Working Capital

• Difference between current assets and current liabilities.
• Indicates company’s liquidity position.

3️⃣ Permanent Working Capital

• Minimum amount of working capital required to keep the business running.
• Constant over time, not dependent on sales volume.

4️⃣ Temporary (Variable) Working Capital

• Extra working capital required to meet seasonal or special needs.
• Fluctuates based on business activity.

Objectives of Working Capital Management

• Maintain liquidity to meet short-term obligations.
• Ensure smooth operations without interruptions.
• Minimize the cost of capital and maximize returns on current assets.
• Manage inventory, receivables, and payables efficiently.

Principles of Working Capital Management

1. Principle of Consistency

• Follow a consistent working capital policy for stability and predictability.

2. Principle of Risk-Return Trade-off

• Higher investment in current assets = low risk but low return.
• Lower investment = high return but high liquidity risk.

3. Principle of Matching Maturities

• Match the maturity of assets and liabilities.
• Short-term assets should be financed by short-term funds.

4. Principle of Cost of Capital

• Use the cheapest source of finance for working capital needs to reduce cost.

5. Principle of Liquidity vs. Profitability

• Maintaining high liquidity (cash) can reduce profitability.
• Must balance between earning returns and staying solvent.

6. Principle of Optimization

• Aim to optimize investment in working capital — not too much, not too little.

Importance of Working Capital Management

Need for Working Capital

Working capital is essential to ensure smooth business operations and to meet short-term financial obligations. A company cannot run efficiently without adequate working capital.

🔍 Key Needs

Daily Operational Expenses

– Payments for wages, salaries, rent, utilities, etc.

Purchase of Raw Materials

– Advance payments to suppliers.

Maintain Inventory Levels

– To ensure uninterrupted production and sales.

Credit Sales to Customers

– Businesses often sell on credit; hence funds are tied up in receivables.

Meet Unexpected Contingencies

– Emergencies or sudden price hikes.

Smooth Cash Flow

– To bridge the gap between cash inflow and outflow.

Classification of Working Capital

Working Capital is classified based on concept and time period:

A. Based on Concept

B. Based on Time Period

Sub-types of Permanent Working Capital

• Regular Working Capital: Constantly needed.
• Reserve Working Capital: For unforeseen circumstances.

Sub-types of Temporary Working Capital:

• Seasonal Working Capital: For seasonal demands.
• Special Working Capital: For one-time bulk orders or campaigns.

Importance of Working Capital

Working Capital Cycle (WCC)

The Working Capital Cycle is the time it takes for a business to convert its net current assets and liabilities into cash.

📉 Cycle Flow

Cash → Raw Materials → Work-in-Progress → Finished Goods → Sales (Credit) → Accounts Receivable → Cash

Formula: WCC=Inventory Conversion Period+Receivables Collection Period−Payables Deferral Period.

Components:

Goal:

Shorter working capital cycle = Faster cash recovery = Better liquidity

Inventory Management

Inventory Management involves controlling the quantity and quality of stock to minimize holding cost and avoid stock-outs.

Types of Inventory

• Raw Materials
• Work-in-Progress (WIP)
• Finished Goods
• Maintenance/Spare parts

🎯 Objectives

• Ensure adequate stock for smooth production/sales.
• Avoid overstocking and understocking.
• Reduce holding and storage costs.

📐 Key Techniques

Cash Management

Cash Management refers to the planning, monitoring, and control of a firm’s cash inflows and outflows to maintain adequate liquidity.

🎯 Objectives

• Ensure sufficient cash for day-to-day expenses.
• Maintain liquidity without holding excess idle cash.
• Optimize the return on surplus funds.

Functions of Cash Management

Cash Management Techniques

• Prepare Cash Budget
• Use Cash Flow Statements
• Maintain Minimum Cash Balance
• Invest in Marketable Securities

Summary Table

Accounts Receivable Management

Accounts Receivable Management involves the monitoring and managing of outstanding customer invoices to ensure that payments are collected promptly and efficiently.

🎯 Objectives

• Maximize cash flow by collecting dues quickly.
• Minimize the risk of bad debts.
• Maintain a healthy credit relationship with customers.

📐 Key Techniques

Factoring

Factoring is a financial arrangement where a business sells its accounts receivable (invoices) to a third party (called a factor) at a discount in exchange for immediate cash.

🎯 Advantages

• Immediate cash flow: Quick access to cash without waiting for payment.
• Reduces credit risk: The factor assumes the risk of bad debts (in non-recourse factoring).
• Outsource collections: Factors often take over the responsibility of collecting payments.

📝 Types of Factoring

Credit Policy

Credit policy refers to the guidelines and terms a company sets to decide who qualifies for credit, how much credit to extend, and the terms of repayment.

📚 Key Elements of a Credit Policy

Objectives of Credit Policy

• Minimize bad debts and delays in payments.
• Increase sales while managing credit risk.
• Optimize the credit terms to balance customer satisfaction and risk.

Financing Working Capital

Financing Working Capital refers to the process of securing funds to meet a business's short-term financial needs (working capital), such as purchasing inventory or paying for overhead costs.

Sources of Financing Working Capital

Types of Working Capital Financing

• Permanent Working Capital Financing:
• Long-term financing to meet the minimum level of working capital.
• Typically funded by long-term loans or equity.
• Temporary Working Capital Financing:
• Short-term funds used for seasonal spikes or temporary needs.
• Can be funded by short-term borrowings or bank overdrafts.

 Summary Table