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WORlCIBG CAPITAL MAIaK-
The management of current asse ts and current
l i a b i l i t i e s and the i n t e r relationehlp t h a t exis to
between them may be tenasd ae working capi ta l manage-
ment.' It is a l s o known as current asse ts management
because it requires much of the f inancia l managervs
time. It is concerned with the problems t h a t a r i s e
i n attempting t o manage the current assets, the current
l i a b i l i t i e e , and the i n t e r relationship t h a t ex i s t
between them.2 I t involves the administration of shor t
t e n a s se t s l i k e cash, marketable secur i t ies , accounts
receivables and inventories. Technically it i s an
in t eg ra l p a r t of the f inancia l management, and it
attempts t o manage and control the current asse ts and
the current l i a b i l i t i e s i n order t o maximise the
p r o f i t a b i l i t y and ensureproper l i qu id i ty i n the
business. Liquidity and P ro f i t ab i l i t y a re two important
and major aspects of business l i f e . No firm can survive
i f it has no l iquidi ty . A f i n may even e x i s t without
making p r o f i t s but cannot survive without l iquidi ty .
1. James, C. Von Home, Financial Management and Policy, Prentice Hall of India, New Delhi, 1973, p.384.
2. Smith, K.V., uanaqement of Working Capital , West publishing Co., New York, 1974, p.5.
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The manner of management of working capi tal t o a
very large extent betennines the success of opera-
t ions of a concern. Though, often business fa i lu res
have been at t r ibuted t o lack of working capi tal , i n
the ultimate analysis it is the mismanagement of
working cap i ta l t h a t w u l d have converted an other-
wise successful business i n t o an unsuccessful onee3
The proper management of working capital is very
important f o r the succems of an enterprise and tha t
i s why it has become a basic and broad measure of
judging the performance of a firm.
WEAHING OF WORK= CAPITAL
Working capital, i n eimple terms, is the
amount of funds which a company must have t o finance
I t s day t o day operations. It can be regarded as
t h a t proportion of canpany8s t o t a l capi tal which is
employed i n short term operation^.^ I t represents the firm's investments i n cash, marketable securi t ies ,
arrounts receivables and inventories l e s s the current
l i a b i l i t i e s used t o finance the current assets. Some
3. N.K. Agrawal, Manaqement of Workinq Capital, Ster l ing Publishers (Pvt.) Ltd . , New Delhi, 1983, p.8.
4. Remamoorthy, V.E., Workinq Capital Manaqement, I n s t i t u t e fo r Financial Management and Research, Madras-34, 1978, p.5.
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r e f e r to t h i s masure a s ne t working capital . But
according t o Waston and Copeland, i f working capi ta l
is what is l e f t a f t e r taking account of current
l i a b i l i t i e s it is redundant t o add the term "netn.
Working Capital Managanent is defined broadly t o
encompass a l l aspects of the administration of both
-rent asse ta and current l i a b i l i t i e s . 5
SCOPE AW IMPORTNICE Olr WORKING CAPITAL WAGEHENT
Working Capital Management i s an in tegra l part
of overa l l f inancia l management. It includes a number
of aspects t h a t makes it an important t op ic f o r study.
It attempts t o manage and control the current asse ts
and the current l i a b i l i t i e s i n order t o maximise
p ro f i t ab i l i t y and ensure proper l iquidi ty i n business.
That is why it has been r igh t ly said t h a t "Working
Capital Management has been looRed upon as the driving
s e a t of a Financial ~ a n a ~ e r ' . ~ It has a l so been
coneidere& as the l i f e blood an& controll ing nerve
centre of a business.' The manner of management of
5. Fred Weston, J, and Copeland Thanas, E., Mana e r i h l Finance, The Dryden Press, ~hfcago, 1986,?;;1$7T--
6. James C. Von Home, Financial Manaqement and Policy, q?.cit., p.384.
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Working Capital t o a very large extent determines the
success of operations Of a concern. Constant Management
is required t o maintain appropriate levels i n the
Working Capital accounts. I t s importance i s seen from
the following factors:
Investment i n current a s se t s represents a sub-
s t a n t i a l portion of t o t a l investments. In some cases
it has been on an average three fourths of the t o t a l
assets. I n the cases of trading concerns they wen
account f o r about 83 per cent of the t o t a l investments. 8
Investments i n current a s se t s and the level of
current l i a b i l i t i e s have t o be geared quickly to changes
in Sales. To be sure, fixed assets investment and long
ten financing are a l so responsive t o var ia t ions i n
Sales. However, t h i s re la t ionship is not a s close and
d i r ec t a s it is i n the case of Working Capital Component. 9
It has a l so been faund t h a t the l a rges t portion of a f in -
ancia l Managers time is u t i l i s e d i n the Managanent of
Working Capital.
8. N.K. Agrawal, 9r.U. p.8.
9. Prasanna Chandhra - Financial Management - Theory and practice, Tata Mc Graw H i l l Publishing Company Ltd., New Delhi, 1984, p.259.
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Character is t ica l ly , current a s s e t s represents
more than half t he t o t a l a s se t s of a business firm.
Slnce they represent such a l a rge investment ' this in-
vestment tends to be re l a t ive ly vo la t i l e , and hence
worthy of the f inancia l manager's careful attention.
Working Capital Management is pa r t i cu la r ly
important f o r small finn. Although such firm can mini-
mise t h e i r investments i n fixed a s se t s by rent ing o r
leas ing p lan t and equipment they cannot avoid investment
i n cash receivables and inventories. Working Capital
Management has acquired important posi t ion and g rea t
s ignif icance i n the recent past. I t i s ref lec ted by
t h e f a c t t h a t f inancia l Manager spends a great deal of
time i n managing current a s se t s and current l i a b i l i t i e s .
Arranging f o r Short Tenn financing,negotiating favourahle
terms of c red i t , control l ing the movement of cash, admi-
n i s t e r ing accounts receivable and monitoring the inves t -
ments i n inventories consume a great deal of time.
WORIUUG CAPITAL WAGEHENT AElb FIXJZD ASSETS MANAGEMEST
Management of f ixed a s se t s i s usual ly considered
t o f a l l within the realm of Capital budgeting, while
the administration of current a s se t s f a l l s within the
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realm, Of Working Capital Management. The management
of current asse t s i s similar t o t h a t of fixed asse t s
i n the sense t h a t i n both the cases the firm analyses
t h e i r e f fec t s on its p r o f i t a b i l i t y and risk. However,
the management of fixed and current assets d i f f e r i n
three important ways: (a) i n managing fixed assets ,
time is very important; consequently: discounting and
canpounding aspects of time element play a s ignif icant
ro le i n cap i ta l budgeting and a minor one in the manage-
ment of current asse t s (b) Secondly, the large holdings
of current asse t s especial ly cash strengthens f inn ' s
l iqu id i ty (and reduce r i s k ) , but it a lso reduce the
overal l p rof i tab i l i ty . (c) Thirdly, the levels of
tixed a s well a s current asse t s depend upon the expected
sales, but it i s only the current asse t s which can be
adjusted with sa les f luctuat ions i n the short run.
PRINCIPLES OF WORKING CAPITAC MANAGEMENT
The f inancial manager of any concern should
consider the following principles while exercising
Working Capital Management:
PRINCIPLE OF RISK VARIATION
The word ' r i sk ' re fe rs t o the immobility of a
concern i n maintaining suf f ic ien t Working Capital t o
pay f o r its l i a b i l i t i e s . I f the Working Capital varies
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r e l a t i v e t o sales, t h e leve l of r i s k t h a t a concern
assumes w i l l a l so vary, and the opportunity of loss o r
gain wi l l increase. I n otherwords, there is a dof in i te
relat ionship between t h e degree of r i sk and the ra te of
return. As a concern assumes more r isk, the opportunity
of gain o r l o s s increases accordingly. A s the level of
Working Capital re la t ive t o sa les decreases, the degree
of r i s k increases. Thus, i f the s i z e of the Working
Capital goes up, the amount of r i s k goes down and the
opportunity f o r loss/gain is likewise adversely affected.''
The s i z e of Working Capital depends upon the
a t t i t u d e of management. A conservative management l i k e s
t o reduce the r i s k by holding a higher level of Working
Capital, while a l i b e r a l management assumes higher and
higher r i s k by minimizing t h i s l w e l . The object of a
management should, howeveg, be t o maintain the level of
Working Capital which would optimize the concern's r a t e
of return.
2. PRINCIPLE OF COST OF CAPITAL
There a r e d i f f e r e n t sources of finance, and each
source has a d i f fe ren t cos t of Capital. It should be
kept i n mind t h a t t h e cos t of Capital is i n inverse
proportion t o risk. This means that , i f the cost of
10. Bardia, S.C., Working Capital Management - Pointer Publishers - Jaipur, 1988, p.4.
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Capital is more-inplying more of Capital, the r e s u l t a n t
r i s k i s less . On t h e o ther hand i f the cos t i s l e s s
implying l e s s of Capital would lead t o more r isk.
Therefore while r a i s i n g finance, the finance manager
should i d e n t i f y a source which would minimise the r i s k
and maximise t h e return;
3. PRINCIPLE OF MATURITY OBLIGATICH
A firm should make every a t tanpt t o r e l a t e mat-
u r i t i n s of obligat ions t o i t s flow of i n t e r n a l l y created
funds. The f a i l u r e of such a match of generation t o
ou ts ide demand would accentuate the r isk.
4. PRINCIPLE OF EOUITY POSITION
The amount of Working Capital invested i n each
segment should be adequataly j u s t i f i e d by a concern's
equity posi t ion, t h a t i s every mpep invested in t h e
Working Capital contr ibute t o t h e n e t worth of t h e
concern. 11
CCNCEPT OF WORKING CAPITAL
Views d i f f e r on t h e concept and d e f i n i t i o n of
Working Capital. The f inanc ia l concept i s the 'gross'
concept. The 'gross Working Capital ' a l s o known a s
cur ren t Capital o r c i rucula t ing Capital is represented
11. Ibid. p.5.
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by the sum t o t a l of a l l current asse ts of the enter-
prise. A s against t h i s , we have the accounting concept,
which i s a 'net concept'. The 'Net Working Capital'
i s the difference between current asse ts and current
l i a b i l i t i e s . These two concepts are not t o be regarded
a s mutually exclusive, Each has i t s relevance i n
speci f ic si tuations. 12
The gross concept is a going concern concept,
i n which management is par t icular ly interested because
f o r the productive u t i l i za t ion of f ixed asse ts a l l the
current a s se t s are necessary. Another aspect of the
gross Working Capital points t o the needs of arranging
funds t o finance current assets. Whenever a need f o r
Working Capital funds a r i se s due to tho increasing
level of business ac t iv i ty o r fo r any other reason,
the arrangement should be made quickly. Similarly, i f
some surplus funds a r i s e suddenly, they should not oe
allowed t o remain id l e , but should be invested i n short
t e n secur i t ies . In short the gross Working Capital is
the t o t a l of a l l current assets. Viz., cash, marketable
secur i t ies , accounts receivable and inventory. As against
t h i s , the n e t concept is useful t o guage the f inancia l
12. Ramamoorthy, V.E., S.S. p.6.
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soundness of a firm and is of special i n t e r e s t t o sundry
credi tors and suppliers of short tenn loans and
This concept a l so covers the question of judicious mix
of long t e rn and shor t tenn funds fo r financing current
assets. According t o Lawrence 3. Gitman, "the Working
Capital is the proportion of a firms current assets
which a re financed fran long term funds.14
Both these concepts of Working capi ta i have t h e i r
own significance. "If the objective is t o measure the
s i ze and extent t o which currents assets are being used,
'gross concept' is useful where a s i n evaluating the
l i qu id i ty posit ion of an undertaking, 'net concept'
becomes pertinent and preferablen. 15
In summary, t he gross and the net Working Capital
concepts present two d i s t i n c t and important facets of
Working Capital management. There is no standard pres-
cr ip t ion se t t i ng out the precise amount of gross o r net
Working Capital, t ha t each enterprise needs. Each company
has i t s own constraints and plans giving r i s e t o indivi-
dual Working Capital problems and the available data
13. James C, Von Home - Finance Management and Po l i Prentice Hall of India (p) Ltd., New el hi, 1973fll p.384.
14. Gitman L.J., Principles of Manaqerial Finance - Harper and Row - New York 1976, p.150.
15. R a m a ~ ~ ~ ~ r t h y , V.E., %.&., p.7.
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have t o be ident i f ied and analysed t o a ld proper
d e d s i o n s .I6
A f i m should maintain a sound Working Capital
posit ion. It should have adequate WorMng Capital t o
run its business operations. Both excessive a s -11
as inadequate Working Capital posit ions a re dangerous
f r an the firm's point of view. Excessive Working
Capital means i d l e funds which earn no prof i t . I n -
adequate Working Capital not only impairs the firms
p r o f i t a b i l i t y but a l so r e s u l t s i n production interrup-
t i ons and i n e f f i ~ i e n c i e s . ~ ~
DANGERS OF EXCESSIVE WORKING CAPITAL
The excessive Working Capital has the following
dangers I
1. It promotes unchecked accumulation u t iriverrtorie3,
gives room f o r inventory mishandling, waste, t h e f t
and losses.
2. It is an indication of permissive c r e d i t po l i c i e s
and s lack col lec t ion procedures, which may adver-
se ly a f f e c t the prof i t s .
16. nishra, R.K.. and Ravishanker, S., Current pers- pect ives i n Publicenterprises ManaqementL A j a n a Publications, New Delhi, 1985, p.316.
17. Pandey, I.X.. Pinancial Xanaq-nt Viluurh Publi- shing House (pvt.) Ltd., New el hi' 2, 1987, p.329.
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3. Excessive Working Capital may develop .I f a l se
complacence which may ult imately degenerate i n t o
managerial i n ef f ic iencies . Impulsive decissions
on expansion may have t o be taken without examining
long term implications on p r o f i t s and growth.
4. Tendencies of accrrmulating inventories t o make
speculative p ro f i t8 grow . This may tend t o make dividend policy l i b e r a l and d i f f i c u l t t o cops with
i n fu tu re when t h e firm Is unable t o make specu-
l a t i v e prof i t&.
DANGERS OF IUADEQUATE WORKIUO CAPITAL
While the adequacy of the Working Capital i s a
v i r t u e the inadequacy is fraught with following dangers;.
1. It s tagnates growth. It beccmes d i f f i c u l t f o r
the firm t o undertake prof i table projects f o r
want of working Capital funds.
2. It becomes d i f f i c u l t t o implement operating plans
and achieve p r o f i t ta rget .
3. Operating ineffeciency creeps in when it becomes
d i f f i c u l t even t o meet day t o day commitments.
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4. Fixed a s se t s a re not e f f i c i en t ly u t l l l zed fo r
t h e lack of Working Capital. Thus the r a t e of
re turn on investments slumps.
5. Paucity of Working Capital renders the f inn
unable t o avai l a t t r a c t i v e c red i t opportunities.
6. The firm loses i t s reputation when it is not i n
a posi t ion t o honour i ts comnitments. A s a
r e su l t , the firm faces t i g h t c r e d i t terms.
Financial managers should, therefore maintain
a r i g h t amount of Working Capital on a continuous
basis, only then a proper functioning of the businese
operations w i l l be ensured. Liquidity r a t i o s and
operating cycle period a r e the two important methods
of assessing t h e adequacy of Working Capital.
S.K. Bhattacharya and others have iden t i f i ed sane
r a t i o s t o judge the effectiveness of Working Capital
managementla and they a r e
1. P r o f i t after t a x a s percentage of Sales ( ~ ~ ~ / ~ a l d s )
2. Sales a s number of times t o t o t a l a s se t s (Sales/
Total asse ts) .
18. Bhattacharya, S.K., Raghavachari, M., and Singh,A.K., Determinants of e f f ec t ive Working Capital Management A Discriminant Analysis approach Uemographed, Indian I n s t i t u t e of Management Ahmedabad. ,
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3. Ouick Assets an Percentages of Current L i a b i l i t i e s
(WCL).
4. Average receivables a s number of days Sales.
(AR/Mo. of days Sales)
5. I n t e r e s t paid a s percentage of p r o f i t before
i n t e r e s t and tax.
Another ind ica to r of t h e adequacy of Working
Capi ta l i s the operating cycle period of an enterprise.
Operating cycle can be determined on a stage-wise
basis. Af ter canputation of operating cycle period of
a concern, Working Capi ta l turnover r a t e can be calcul -
a ted and then t h e i r turnover r a t e can be used t o deter-
mine t h e Working Capita? requirements of an undertaking.
Placing t h i s along with t h e required amount of Working
Capi ta l w i l l give the excess amount locked up i n the
enterpr ise . The c a p a r i s o n o f - t h e norms suggested by
Tandon Comnittee r e l a t i n g t o maintanance of Working
Capital t o the ac tual8 obtained i n the undertakings
w i l l a l s o give a b e t t e r understanding of the excess o r
d e f i c i t Working Capital. For the smooth running of
any enterpr ise , adequate mount of Working Capital is
necessary and i n its abaence, t he f ixed a s s e t s cannot
be ga in fu l ly employed.
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Apart from the above, thare is ye t another
method of estimating Working Capital. It is con-
ventional method. According t o the conventional
method, cash inflows and outflows are matched with
each other. More emphasis is la id down on l iquidi ty
and greater importance i s attached to current ratio,
l iqu id i ty r a t i o etc.. which pertain to the l iquidi ty
of an enterprise.
STRUCl'URE 'OF WORIUNO CAPITAL
Structure of Working Capital means the am-
Ponents of the Working Capital. The basic components
of the Working Capital a re current assets and current
l i a b i l i t i e s . The main elements of current assets are
cash and Bank Balances,receivables, inventories and
other quick resources l i k e short term investments.
Current l i a b i l i t i e s include payables, bank over draf ts ,
outstanding expenses proposed dividends, teuc payable
and incomes received i n advance.
The management of an enterprise should t r y
t o take maximrrm utiliscrtion of its canponenta a t the
minimum poesible cast. This is highly dependent on
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t he s t r u c t u r e of Working capital . lP The following
a r e the important f ac to r s i n the analyr is of the
s t ruc tu re of Working Capital.
INVENTORY
Inventory general ly cons t i tu t e s a major portion
of cu r ren t asset.. The p r o f i t a b i l i t y of thm business
t o a l a r g e r extant depends upon the turnover 6f tho
Working Capi ta l and this i n turn depends upon the
turnover of t h e inventory. The term 'Inventory', means
the aggregate of those items of tengibla personal pro-
pe r ty which (1) a r e held f o r s a l e i n the ordinary
course of business, (2) are i n the process of production
of sa les , o r (3) a r e t o be current ly consumed i n pro-
duction of goods o r services to be avai lable f o r sale.
The i n v e n t o ~ y according t o the abwe def in i t i on
includes the following1 Raw materials, wrk-in-pr'ogrese
and f in ished goods.
RAW MATERIALS
Raw Materials means the items which a re held i n
t h e i r o r i g i n a l form, f o r processing and production.
I t is e s s e n t i a l t h a t the production should not suffer
19. Ja in , Ravi K., Workinq Capital Hanaqment of State Enternr ises i n India, National Publishing Honse, chaura Rasta, Jaipur, 1988, p.18.
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' f o r want of stock. POr ensuring this, the purchase
of raw materials i n large quantities may minhise
purchasing overheads, increase the discounts,-at the
same time, excessive raw materials may lead t o incurring
higher carrying costs and wastages. Therefore t h i s
should be controlled by properly set t ing the m a x i m u m
and minimum levels of stocks, reordering level and
reorder quant i t ies etc.
WORK IN PROORESS
work i n progress inventory i s a camnon item i n
a l l the manufacturing concerns, because, no f i r n may
be able t o canpelete the manufacturing instantaneouely.
A t any phase of production, there w i l l be semifinished
goods o r work i n process. A t times the production
process w i l l be delayed so a s to sa t i s fy the part icular
choice, t a s t e and expected dwand of customers.
FINISHED GOODS
It is very important t o maintain a proper level
of finished goods i n a concern. Danger would be f e l t
on s i tua t ions of excess o r lower inventory. I f a firm
does not have enough etock of finished goods, it w i l l
not be i n a position to meet sudden demands of custaners.
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I t may sometimes lose sales because the needed sto&
of finished goads may not immediately be available.
It may be economical t o hold a reasonable quantity of
finizhed goods. The f l ex ib i l i ty afforded by such an
inventory makes it possible f o r a firm t o meet sudden
o r unanticipated damand of custaners relatively a t
lower costs.
There a re tvo advantages of high level of
finished stocks They are (a) minimisation of loss of
sales and (b) minimisation of high additional costs
due t o many number of production operations. However,
the otheraide of the picture is, the high inventory
means high investments, which resul ts i n high carrying
costs (the main factor of which being interest) .. Therefore management should s t r ike a proper level of
finished goods inventory, keeping i n view the various
factors affecting it, The objective of the inventory
management would be the minimisation of id le cost of
men and machine caused by rhortage of raw materials,
s tores and spare parts and also t o keep low the inventory
ordering cost, (2) carrying cost, and the (3) investment
i n inventory and obsoleecence loSse.6..
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In most of the business organisations, the
bulk of sa les would be on credit. This is probably
because of the f a c t tha t when l ibera l c red i t f a c i l i t i e s
are made available, the sa les would increase. I n t h i s
sense, receivables play aa important role i n emuring
a higher turnover f o r the firm cannmed. The practice
of carrying receivable* haa a few advantagrseuch as
(1) the reduction of collection costs over cash collsc-
tion, (2 ) reduction i n var iab i l i ty of saler , and
(3) increase i n the level of near term sales.
Credit and collection policies significantly
influence Working Capital requirements. When properly
formulated and executed, reduce the need of Working
Capital f o r operational purposes. Good credi t and
col lect ion pol icies aid in; sales promotion, so t h a t
the p r o f i t s b e m e more. Soundly conceived and exe-
cuted c red i t collection pol icies tend t o reduce the cost
of business. Finally, c red i t and collection pol icies
are necessary f o r the rnaintanance of good customer
relations.
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Receivables const i tute a major canponant of
Working Capital, and a o it require the name type of
planning and control a s cash and inventories. The
volume of receivables outstanding a t any one time is
determined by an enterprise 's c red i t and collection
pol icies . The ro le of receivables i n the t o t a l f in-
ancial s t ruc ture depends on the enterprises c red i t
and col lect ion po l ic ies which i n turn i s very much
re la ted t o Working Capital.
CASH AND W K EIALAWCES
Cash is the most l iqu id asset t h a t a business
owns. It includes money and other i n a t m e n t s as
cheques, money orders o r bank dra f t s etc. Cash t o a
business is akin t o the blood f o r a human body. As
the blood imparts l i f e and strength, the cash imparts
p r o f i t s and solvency t o an enterprise.
A large bank balance reveals a sound l iquid
position. However from f inancial management's point
of view this pract ice is disapproved as it leads to
the holding of an asse t which is devoid not only of
earning power but i s on the contrary, expensive t o
retain." While the proportion of current assets held
20. Ibid. p.22.
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i n the form of cash is very small, often between one
per cent and three per cent i t s effecient management
i s crucial t o the solvency of the business because in
a very important sense oash is the focal point of funda
flow i n a business.21 The objectives of cash management
a re t o make the most effect ive use of funds on the
one hand, t o accelerate the inflow and t o decelerate
the outflow of cash on the other hand.
It has become a pract ice with the modern
business organisations t o invest a par t of the i r ear-
nings i n asse t s which a re eas i ly convertible in to cash
(Marketable Securities) t o avoid too much redundant
cash. Sdch assets may be Government Securities, bonds
debentures and shares t h a t a re readily saleable without
loss of value.
CURRENT LIABILITIES
Current assets are not the only factor which
count i n designing the s t ructure of Wcrking Capital.
There is the l i a b i l i t i e s s ide also, such a s trade
credi tors , b i l l s payable, bank overdrafts, tax payables,
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21. Prasanna Chandhra, &.&., p.277.
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proposed dividends, outstanding expenses etc. Taxes
and proposed dividends have major influence on the
Working Capital s t ruc ture of a bwiness. Corporate
incane t a x reduces the ne t earnings of an enterprise.
However, the management does not usually have a high
degree of f l e x i b i l i t y i n these matters and hance the
focus of the management is therefore limited to
handling of current assets . 22
DETJSWINWTS OF WOIU(IPIQ CAPITAL
There a re no s e t rules o r formulae t o deter-
mine the Working Capital requirements of the firms.
A l a rge number of fac tors influence the Working
Capital needs of the firm. A l l the factors are of
d i f f e r e n t importance. Also, the importance of those
fac tors change frcnn firm t o firm and a l so f o r a firm
over time. Those fac tors are: (1) Nature and Size
of business, (2) Manufacturing cycle ( 3 ) Business
f luctuat ions (4) P r d u c t i o n policy (5) Firms c r e d i t
policy ( 6 ) Availabi l i ty of c r e d i t ( 7 ) Growth and
expansion a c t i v i t i e s (8) P r o f i t margin and p r o f i t
appropriation ( 9 ) Price leve l changes and l a s t l y
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(10) Operating efficiency. Depending upon the
app l icab i l i ty of these concepts t o the f i rn , the
canposition and quantity of Working Capital -may
vary from firm t o firm.
OPTIMUM LEVEL OF CURRENT ASSETS
The f inancial manager ahould deternine the
0 9 t h ~ l eve l of current asse t s so t h a t the wealth
of the share holders be maximised. I n fact , optimum
leve l for each typo of current asaeta mhould ba
fixed.
CURRENT ASSETS AND FIXED ASSETS
A firm needs fixed and current asse t s to
support a par t i cu la r l eve l of output. However, t o
support the same leve l of output, the firms may have
d i f f e r e n t l eve l s of current assets. As the firm's
output and sa les increases, the need f o r current
asse t s a l s o increases, but not i n d i r e c t proportion
t o output, it increases a t a decreasing rate , because
of the economies of l a rge scale operations.
The leve l of Current asse t s can be measured
by r e l a t i n g it t o fixed assets. Assuming a constant
l eve l of fixed assets, a higher current asset/fixed
-
asse t s r a t i o indicates a consemative current asseta
policy and a lover Current asse+s/Mxed wae t . means
an aggressive current asset. policy. Other things
remaining constant, conservative policy implies
g rea te r l iqu id i ty and lower risk: While an aggre-
ss ive policy indicate a higher r i s k and poor
liquidity.23 The current assets policy of the moat
firms mby f a l l between these two extremes.
The firm would make j u s t enough investments
i n currents assets, i f it were possible t o estimato
working cap i ta l needs exactly. Under perfect cer-
taibnty, the current asse t s holdings would be a t the
minimum level. A large investments i n current assets
would mean a low r a t e of return on investment, a
smaller investments i n current assets, on the other
hand, would mean interruption i n production and
sales, because of frequent stock outs, Md inab i l i ty
t o pay f o r credi tors i n time.
23. Pandey, I.M., Financial Management, Vikas Publi- House, Pvt. Ltd., New Delhi 2, 1987, p.336.
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However, as it is not possible t o estimate
working c a p i t a l needs accurately, the firm muat
decide about the l eve l s of current asse t s to bo
carried. The current asset8 holding of the f i m
w i l l depend upon i t s worklng cap i ta l policy. It
may follow a conservative o r an aggressive policy.
These po l ic ies have d i f f e r e n t rirk-return implica-
tions. A conservative policy means lower returns
and r i sk , while an aggressive policy leads to higher
return and higher r isk.
Apart from the, working cap i ta l policy leading
t o risk-return tangle, a firm may face two important
but conf l ic t ing a i m s of Working cap i ta l management,
namely p r o f i t a b i l i t y and solvency. Solvency re fe rs
t o the f i m s continuous a b i l i t y to meet maturing
obligations. To ensure solvency, the firm should be ,
very l iquid, tying up of current asseta in i d l e in -
vestments increasing cost and decreasing prof i t ab i l i ty .
TO have higher p r o f i t a b i l i t y , the firm may have to
s a c r i f i c e solvency and maintain a re la t ive ly low leve l
of current assets. Its p r o f i t a b i l i t y may bupmve as
l e s s funds are t i e d up i n i d l e current asseta, but
solvency would be threatened a8 a consequence t o it.
-
In determining the optimum l w e l of current assets,
the firm should balance the prof i tabi l i ty solvency tangle
by minimising the t o t a l cost (cost of l iquidi ty and cost
i l l i qu id i ty ) . Pig.III.1 COST TRADE 01F '
'-----..---' Level of current assets Optimum level of
{ U
current asse ts
Total Cost
Cost of Liquidity Minimum y , I I
I Cost of I l l iquidi ty I I
Sources I.M. Pondey m.Cit., p.338.
That level of current asse ts where the a m of these two
cost i s minimum i s the optimum level of current assets.
TYPES OF WORKING CAPITAL
The working capi ta l tha t a firm would require
may ba broadly divided in to two namely permanent,
f ixed o r regular bwrklng capi ta l and tearporaq,
fluctuating/Parfable o r seasonal workinp capital.
-
~enahnent working capi ta l is that level of curmnt assets
which is continuously required by the firm t o carty on i t s
business operations without any interruptions. Teporary/
variable working capi ta l i s t ha t level of current assets
which are required over and above the permanent working
capital ,24 depending on the changes i n production and sa les
levels. Both, the types of working capi ta l are necessary
t o f a c i l i t a t e production and sales through operating cycle.
Some times it i s c lass i f ied in to three viz., penanent,
temporary and seasonal. These clbssifications of working
capi ta l concept i s necessary f o r the purpose of taking
financing decisions.
7 Fig.III.2 PE- MTD T- WORKIW; CAPITAL
Permanent working capita:
Source: BARDIA, S.C., Working -pita1 Nanagaaent,p.l3.
24. Joy, D.H., Introduction t o Financial Management, House vood J l l i no r s ~ i c h a r d , D., Irwin 1977, p.407.
-
The permanent working capi ta l i s stable over
tima, while t e p o r a r y wrking capi ta l i s f luctuating
scmetimss i n c m ~ i n g and some other times decreasing.
a s i n Pig. 111.2. Hovsver f o r a growing firm, the
permanent working cap i t a l may not be stable, it would
a l so be increasing a s it grows and therefore the
permanent working cap i t a l l i n e w i l l not be horieontal
s t r a igh t l i n e as i n the previous case. It w i l l be
gradually r i s ing a s i s shown i n Pig. 111.3.
Pig.III.3. PERHWEM' AND TEUPORARY WORKING CAPITAC OF QROWING COMPAElY
Temporary o r Fluctuating Working Capital
- Y Permanent Working -- Capital 1 +
0 T lrne
Source: Bardia, S.C., Working Capital Management, p.14.
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Ogtfmrm! l eve l of working cap i ta l has been
emphasised because both excessive as well as bade-
quate working cap i ta l positions are-dangerous ftom
the firm's point of view. While excessive vorking
cap i ta l means i d l e funds vhich earn no prof i t s f o r
the firm, paucity of working capi tal not only impairs
f i rni3profi tabi l i ty but a l so m s u l t s i n production
interrppt lons and inefficiencies.
FmWCMG OF WORKING CAPITAL
The financial manager should determine the
optimum leve l of working cap i ta l (Gross) so t h a t
t h e wealth of the share holders be rnaxtmisad. The
f i n a needs fixed and current assets t o support a
par t i cu la r l eve l of output. However, t o Bugport the
same leve l of output, the firm can have different
l eve l s of current assets. The current assets of a
firm may be financed by e i t h e r long term o r short
term and o r spontanaous sources of financing. The
inportant long te rn sources of finance are shares,
debenture, preference shares retained earnings and
debts f ram f inancia1 inst i tut ions. Short term source8
of finance a r e shor t term cred i t (~ank lo-, corrmer-
c ia1 papers and factoring receivables). Spontaneour,
-
financing re fe rs to the aukmatic sources of short
t e r n funda l i k e t rade c red i t s and outatanding ex-
penses. hey a r e cos t free. Thus, the real choice
of financing current peseta is In between short
term and long term sources. Even assuming t h a t the
l eve l of spontaneous current l i a b i l i t i e s is deter-
mined by extraneous fac tors ( l i k e business practice,
incoma tax and dividend pol icies etc.) the important
question i n gross working capital/currant asaeta
financing l e t What should be the re la t ive proportion
of shor t t e r n and long term aouroa of finance. To
f ind out a solut ion f o r the above question, the
following th ree approaches a re resorted t o by the
finance managers.
The d i f f e r e n t approaches f o r financing the
current asse t s are: (1) matching approach, (2 ) conaer-
vat ive approach and (3) aggressive approach.
A firm can adopt a f inancial plan which
involves the matching of the expected l i f e of the
a s s e t s with the expected l i f e of the source of funds
raised t o finance it. Thus a ten year loan may be
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raised t o finance a plant w i t h an a x p e c t d l i f e of
ten years; Stock to be sold i n t h r i t y days may be
financed with a t h i r t y days bank loan and #o on.
The j u s t i f i c a t i o n f o r the -act matching is that,
s ince Me purpose of financing i m to pay f o r tha
assets , the financing should be relinquished when
the a s s e t is expected t o be relinquished. Using
long term finance f o r short terra asse t is expensive
as the funds w i l l not be u t i l i r e d f o r the f u l l period.
Similarly, financing long term assets with short
term finance is cost ly a s well as inconvenient an
arrangements f o r the new short tenn-finance w i l l
have to be made an a continuing basis. Thus, when
the firm follows matching approach (also known as
hedging approach), long term finances w i l l 'be used
to finance fixed asse t s and permanent current assets
and s h o r t term source t o finance temproary o r variable
current assets. However, the exact matching is not
possible because of uncertainty about the expected
l i v e s of assets. This is shown i n Fig.III.4.
-
Pig.III.4 FINANCING UUDER HATCHING PLAN
X Temperory cur ren t r
a s s e t s Short Term Financing
Permanent cur ren t a s s e t s Long Term Financing
__C____
Fixed a s s e t s
i Time
Sources Pandey, I.M., Financial Management, p. 341.
The f i n ' s f ixed a s s e t s and permanent cur ren t a s s e t s
a r e f inanced with long term funds and as the l w e l of
these a s s e t s increases, t h e long t e n f inancing leve l
a l s o increases. The temporary o r var iab le current
a s s e t s a r e financed with s h o r t term funds and a s t h e i r
l e v e l increases, the l e v e l of s h o r t term financing a l s o
increases.
-
An exact matching plan may not be possible
t o be adopted i n practice. A firm may adopt a
conservative approach i n financing i t s current and
f ixed assets. The financing policy of the f inn ir,
sa id t o be conservative vhen it depends mom on
long term f ~ m l S f o r i t s financing needs. i.e..
the firm may finance its permanent current asse t s
and a p a r t of temporary current asse t s with long
term finances. !ITIus, i n periods when the tinn has
no temporary current assets , it s tores l iqu id i ty by
invest ing surplus funds i n t o marketable securi t ies .
The conservative plan r e l i e s heavily on long term
financing, and therefore, i s l e s s risky.
AGGRESSIVE APPROAQ1
A firm may sa id t o be aggressive i n financing
i ts a s s e t s *en it uses more of short term finance
than warrented by the matching plan. Under an aggre-
s s ive policy, the firm finances a p a r t of i t s per-
manent current a s s e t s a l so with short term financing.
Sane extremely aggressive firms may even finance a
p a r t of t h e i r fixed asse t s with short term financing.
The r e l a t i v e l y more use of short t e rn finance makes
the firm more risky. This is i l lustrated.with the
help of the following Figure.
-
FIG 111.5 AORESSWE FINANCIMO
*n L 'n VI
FIXED ASSETS
short Term h d a
Long Term ' Funds
Sources Pandey I.M. Financial Managamant OJ.C&., p.343
TEQWIQUES OF WORKXUG CAPITAL ANALYSIS
A Study of the causes of changes t h a t take
place i n the working capi ta l balances from time t o
time is necessary.25 The objectives of euch an analysia
is t o f i n d out whether the management i s u t i l f s ing
the working cap i t a l ef fec t ively o r not,-, o r t o
find out whether the amount of vorking capi ta l
25. M.H.B. and E.S., Motaal: "Working Capital i t s role i n the short run l iqu id i ty Policy of Indus tda l concern* Accountins Research Vo1.9, 2988, p.266.
-
is adequate, excess o r inadequate. It may also be
t o f ind out whether the f ino in question i s i n a
posi t ion t o pay i t s shor t term debts pmmtly o r not
and f i n a l l y it may f ind ou t the source of working
capi tal .
There a r e so many techniques t o analyae th.
working c a p i t a l of an enterprise. Among them, the
most frequently w e d a m (1) Ratio analysia (2) Iunda
flow analysis, (3) trend analysis and (4) Cost wlune
p r o f i t analysis etc.
RATIO ANALYSIS
Ratios a r e simply a means of highlighting i n
ar i thmatical terms the relat ionship between figures
drawn from f inanc ia l statements.26 Ratio analysis
takes two forms: (1) behaviour of ra t ios w a r a period
of years t o determine trend, (2) comparing- ra t ios of
one concern with those of other concern i n the same
l i n e of business. This can be used by management as
a technique of analysis t o judge the efficiency with
which working cap i ta l is being used i n an enterprise.
26. Pearson Hunt and William Donaldson, Basic businesr finance t e x t and cases, Richard D., Irwin House Homewood, I l l h o i e , 1966, p.141.
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The Important r a t i o s t h a t can be used f o r
management of w r k i a g c a p i t a l are: (1) turnover of
working c a p i t a l (net aales/net working cap i ta l )
(2) cur ren t r a t i o (3) current debt t o tangible ne t
worth r a t i o (current hiabi l i t ies / tangible net worth).
Although r a t i o analysis is used widely, it
should be kept i n mind t h a t "no one r a t i o w i l l give
t h e e n t i r e picture, but they do tend t o give indi-
c a t i o n ~ , which cumulatively aas ie t considerably i n
appraisal of f inanc ia l posi t ions and operations of
the organisation. 27
This analysis is an e f fec t ive management tool
t o study how funds have been procured f o r the business
and how they have been employed. This technique helps
to analyse changes i n working cap i ta l components bet-
ween two dates.
27. Herald Bierman, Financial Accountin the?=, Tho k c Millan Compapy, Hew York, 1st Giti;:-, p.255.
-
f n Spite of its We for owners and creditor8
in f inancial deciaion making, it does not c l d f y
the importance of movements i n the working capital
structure. Ruther , this technique can be used only
by the internal managanent i n i ts control of working
capi tal and does not throw l i g h t on the quertions
whether the cap i ta . is being wed most affbciently
o r whether the current financial position of the firm
h a improved o r not.
Trend analysis make. it easy to underatand
the changes i n an item o r a group of iteas w e r a
period of time and to draw conclwions regarding the
changes i n data. For t h i s analysis, a baae year is
chosen and the amount of t h a t item relat ing t o the
base year i s taken equal t o 100 and i n d w numbers
are calculated f o r the other years bared on the amount8
of t h a t item In those years. This i a a dynamic method
of analysis showing the changes over a period of t h e .
Since it indicates the direction i n which a
finn is going, W e analysis may be useful i f the
analyst wants to study the changes over a long period
-
of time, it may be applied i f a t a11 the period of
etudy i n not learn than 5 yearn, so that it may ba of
help i n forecasting the future trends.
COST VOLUME PROPIT MALYSIS
Under t h i s method cash break even chart is
prepared with t h e p u p s 8 of showing cash rewrements.
Certain items may have to be paid f o r i n cssh while
others not. Credit may have been allowed to customer.
f o r goods and services eold or granted t o the enterprire
f o r materialssupplied t o it during a part icular period,
and t h e cash break even chart shows only the actual
payments and not the expenses incurria.
A break even point is also the most important
technique f o r analysing the working capital.. The cost
volume p r o f i t analysis deals with the net e f fec t of
changes i n cost, p r ice and volume on profi ts . It not
only helps the management i n p r o f i t projection but
a l so i s very useful i n v i r tua l ly a l l decision making
-
5una other trchnipuor l ike cash flow analysis
and a f e w mtati~tical-mathamatical techniques l i k e
index number, range, correlation and repression
analysis a re a l so used i n this.
CoNausIca
The management of current assets and current
l i a b i l i t i e s and the i n t e r relationship that axists
between them may be termed as working capi tal mana-
gement. It involve the administration of short term
asse t s l ike, cash Marketable securi t ies accounts
receivable and inventories on the one s ide and the
current l i a b i l i t i e s on the other and tha t is why techni-
ca l ly it is considered a s an integral par t of financial
management.
Because of i t s impartance i n corporate sector,
it has been considered as the l i f e blood and controlling
nerve centre of business and also looked upon as the
driving 'seat of a financial manager.
A firm requires both the fixed assets and
current assets, however the effect ive u t i l i sa t ion of
the fixed asse t s depends upon the amount and usage of
-
the current assets. A financial manager has t o consider
the principles of r i sk variation, cost of capita1,maturity
obligations and equity positions in exercising vorkiag
capi tal managenant. These principler may help to undo$-
stand t h a t adequacy i s a vir tue surplus is not. TO
ident i fy the adequate amount of working capital and
effect ive u t i l i r a t i o n of it the finanm manager can
also use same of the accounting rat ios as well.
The analysis of working capital structure may
help t o take m a x i m uti l izat ion of i t s canponentr a t
the minimum possible cost. This may also help t o locate
the r igh t proportion of the components like, Inventory,
Sundry Debtors, accounts receivable, and cash and Bank
balances. The determinants of the Working Capital struc-
ture are the nature and s ize of business, manufacturing
cycle, business fluctuations, production policy, f i n s
c red i t policy, avai labi l i ty of credit, gruwth and expans-
ion ac t iv i t i es , p rof i t margin and price level changes.
While detennining the optimum level of current
assets, the financial manager may be entangled i n the
l iquidi ty Vs. p rof i t ab i l i ty and r isk Vs. return tangles.
While l iqu id i ty may reduce the risk, it lacks profita-
b i l i t y the profitable use of the current assets may
-
lack l i q u i d i t y and i n the same way when he invests
the current asse t s i n a high incaw earning invent-
ments, it increases the r isk, while t rying t o raduco
the r isk, he may ge t a decreased return. merefore
while determining the optimum level of current assets,
the firm should balance the prof i t ab i l i ty solvancy
tangle by minimising the t o t a l cost by maintaining
i t s current asse t s a t t h a t l eve l where the sm of
the t h e cos t of l iqu id i ty and i l l i q u i d i t y i s minimmn.
Fi9.111.1.
For any firm, both the permanenr and temp-
rorary forms of working cap i ta l a r e necessary t o
f a c i l i t a t e production and sa les through operating
cycle. The quantum and s i z e of permanant and temp-
orary forms of working cap i ta l may d i f f e r ran firm
t o firm and a l s o fmm time t o t h e depending upon the
nature of business and leve l s of act ivi ty . Depending
upon the requirements, the r igh t sources have t o ba
tapped t o minimise the costs and r i sks and o p t M s e
the l i q u i d i t y and prof i t ab i l i ty . Eventhough there
are conservative, aggressive and matching approaches
of financing of working capi tal , t o guide, the matching
concept alone may help achieve the goals of finmcing.
-
There u e many tachniques of working
c a p i t a l analysia and out of them, the r a t i o analysis,
fund and cash flow analysis, trend analyeis are more
popular. O+ourse the analysis l i k e correlation,
regression, time s e r i e s and c o s t mime p r o f i t
analysis a r e a l s o used. But however the fonner
group may be f o r t h e aggregate use while the l a t t e r
may have appropriate use while deciding t h e indivi-
dual item of the current assets.
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