Working Capital Management | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• The inadequacy of working capital often leads to business failure, underscoring the critical importance of effective working capital management for business success. This entails overseeing both current assets and liabilities, a task that many companies have struggled with in recent years.
• While a firm may persist without generating profits, its survival hinges on liquidity. Working capital management functions akin to the heart in the human body, serving as a vital aspect of financial management. The financial manager must ascertain the appropriate level of working capital funds and strike the optimal balance between current assets and liabilities. Furthermore, they must ensure that working capital is financed using suitable sources and that short-term obligations are met punctually.

Definition of Working Capital:

• Working capital is defined as the surplus of current assets over current liabilities.

Concept of Working Capital Management:

• Two concepts govern working capital: quantitative and qualitative, also known as gross and net concepts, respectively.
• The quantitative concept defines working capital as the total of current assets, treating current assets as gross working capital.

Conversely, the qualitative concept sheds light on the source of financing capital. Here, working capital is defined as the excess of current assets over current liabilities. L.J. Guthmann described working capital as the portion of a firm's current assets financed by long-term funds. The surplus of current assets over liabilities constitutes net working capital, representing the amount of current assets remaining after settling all current liabilities. Both concepts hold significance: the gross concept is useful for assessing the utilization of current assets, while the net concept is essential for evaluating liquidity. Understanding the nature of current assets and liabilities is pivotal in comprehending working capital.

• Current Assets: Current assets, with their short lifespan, facilitate the day-to-day operations of a business within a twelve-month accounting period. These assets swiftly convert into other forms, with cash balances typically held idle for a brief period, accounts receivable lasting 30 to 60 days, and inventories maintained for 30 to 100 days.
• Current Liabilities: Current liabilities arise from purchases made on credit from creditors or sellers, known as accounts payable. These liabilities are anticipated to mature within the accounting cycle of one year and are crucial for assessing a firm's financial health.

Types of Working Capital

Working capital can be classified based on business needs into two categories:

Based on Periodicity:

• The demand for working capital is continuous, with varying needs during specific seasons or peak business periods. Working capital can be categorized as follows:

Permanent Working Capital:

This type, also known as Fixed Working Capital, represents the portion of working capital permanently invested in current assets to facilitate smooth business operations throughout the year. It includes the minimum level of current assets necessary for day-to-day business activities, such as maintaining a minimum stock of raw materials or cash balances. The amount of permanent working capital varies based on the company's size and growth. Permanent working capital can be further classified into:

• Regular Working Capital: This is the minimum amount of working capital required to sustain basic operations, covering expenses like wages and salaries.
• Reserve Margin Working Capital: This additional working capital serves as a buffer for unforeseen contingencies, such as strikes or economic downturns.

Variable or Temporary Working Capital:

Variable working capital fluctuates and is temporary in nature, changing in response to shifts in business volume. It can be further divided into two sub-groups:

• Seasonal Variable Working Capital: This additional capital is required during peak business seasons to address seasonal fluctuations in demand for raw materials, such as cotton, jute, or sugarcane. Industries may need to borrow funds for short periods to finance seasonal operations.
• Special Variable Working Capital: Extra working capital may be necessary for unexpected events or special projects, such as extensive marketing campaigns or unique business ventures.

Distinguishing Permanent and Variable Working Capital

• The differentiation between permanent, or fixed, working capital and variable, or temporary, working capital holds significant importance in both the operational cycle and fund procurement. Every firm requires a constant minimum level of current assets to sustain its business operations continually. This essential level of current assets is termed as permanent or fixed working capital, resembling the firm's fixed assets in its enduring nature.

• The requirement for working capital, beyond the permanent level, varies depending on changes in production and sales.
• As illustrated in the figure below, permanent working capital remains consistent over time, whereas temporary working capital fluctuates, sometimes rising and sometimes falling. However, the line representing permanent working capital may not be horizontal if the firm's need for permanent capital changes over time. For a growing firm, the disparity between permanent and temporary working capital can be depicted as shown below.

Based on the concept:

Working capital is categorized into two types based on the concept:

• Gross Working Capital: Gross working capital represents the total investment in current assets. It provides insight into the utilization of working capital and offers an understanding of the company's financial position. The concept of gross working capital is widely recognized and accepted in the field of finance.
• Net Working Capital: Net working capital is calculated as the difference between current assets and current liabilities. It signifies the surplus of current assets over current liabilities. A positive net working capital indicates the company's ability to fulfill its short-term obligations. The concept of net working capital serves as a measure to assess the creditworthiness of a company.

Factor determine working capital

Various factors influence the amount of working capital required by a business. These determinants include:

• Nature of Companies: The size and type of business significantly impact the composition of assets. Small companies typically have a smaller proportion of cash, receivables, and inventory compared to larger corporations. Different industries also have varying asset requirements based on their operational nature.
• Creditors' Demands: Creditors seek assurance that their loans are adequately secured. They prefer assets that exceed liabilities in value to mitigate risks associated with lending.
• Cash Needs: Cash is vital for sustaining operational cycles. A minimum cash level is necessary to facilitate ongoing business activities and maintain favorable credit relationships.
• Nature and Size of Business: The working capital needs of a firm are influenced by its industry type and size. Trading and financial firms require substantial working capital investments due to lower fixed asset investments. Retailers and certain manufacturing businesses, such as tobacco and construction firms, also have significant working capital requirements.
• Time: The time required to manufacture goods affects the size of working capital. Longer production cycles generally require greater working capital investment. Additionally, inventory turnover and unit costs of goods sold impact working capital requirements.
• Sales Volume: Sales volume directly affects the size and components of working capital. As sales increase, so does the investment in working capital to support operational activities, covering costs, inventories, and receivables.
• Purchases and Sales Terms: Favorable credit terms for purchases and sales can reduce the need for working capital. Longer credit periods allow firms to hold less cash in inventory and rely on supplier or creditor credit. Strong credit relationships with banks can also lower working capital requirements.
• Business Cycle: Working capital needs fluctuate with business cycles. During periods of economic growth, businesses typically require more working capital to support expansion, while downturns may necessitate less working capital.
• Production Cycle: The duration needed to convert raw materials into finished products influences working capital requirements. Shortening the production cycle minimizes working capital needs.
• Liquidity and Profitability: Firms must balance liquidity and profitability when determining working capital levels. Higher liquidity levels increase working capital but may reduce profitability, while lower liquidity levels pose greater risk but potentially higher profits.
• Seasonal Fluctuations: Seasonal variations in sales impact variable working capital needs. Some industries experience seasonal demand patterns, requiring larger working capital investments during specific periods.

Operating Cycle

The duration of time required to complete the sequence of events right from purchase of raw material/goods for cash to the realization of sales in cash is called the operating cycle, working capital cycle or cash cycle.

Operating Cycle of Manufacturing Cycle: 

The depicted operating cycle in the figure pertains to a manufacturing company, wherein cash is required to procure raw materials that are then transformed into work-in-process and subsequently into finished goods. These finished goods are then either sold for cash or credit, and eventually, the receivables are collected.

Operating Cycle of Non-Manufacturing Firm

Non-manufacturing entities like wholesalers and retailers do not undergo the manufacturing process. Instead, they directly convert cash into finished inventory, which is then converted into accounts receivable and subsequently back into cash. The operating cycle of a non-manufacturing firm is illustrated below.

Operating Cycle of Service and Financial Firms

In addition to this, some service and financial concerns may not have any inventory at all. Such firm have the shorter operating cycle.

Liquidity Versus Profitability: Risk-Return Tangle

• The ideal scenario for a firm would be to invest precisely enough in current assets to meet its working capital needs. In a situation of perfect certainty, this investment would be minimal, as excess investment would yield insufficient returns, while insufficient investment would lead to disruptions in production and sales due to stock shortages and delayed payments to creditors.
• However, since it's impossible to accurately predict working capital requirements, firms must decide on their current asset levels based on their working capital policy, which can be either conservative or aggressive, each carrying its own risk-return implications.
• A conservative policy entails lower returns and risk, while an aggressive one yields higher returns but also higher risk. The primary goals of working capital management are profitability and solvency.
• Solvency, in a technical sense, refers to a firm's ability to meet its obligations as they mature. To ensure solvency, firms maintain a relatively high level of current assets, allowing them to meet creditor demands promptly and maintain smooth operations.
• While a liquid firm faces less risk of insolvency, maintaining liquidity comes at a cost. A significant portion of funds is tied up in idle current assets, affecting profitability. On the other hand, striving for higher profitability may lead to sacrificing solvency by maintaining a lower level of current assets, exposing the firm to greater risk of cash shortages and stockouts.
• Therefore, firms must strike a balance between profitability and solvency by minimizing the total cost of liquidity and the cost of illiquidity. This cost trade-off can be viewed in terms of the costs associated with maintaining a particular level of current assets.

There are two types of costs involved:

• The cost of liquidity: If a firm holds too much liquidity, its rate of return decreases as funds sit idle in cash, excess inventory, and large receivables. Thus, the cost of liquidity increases with higher levels of current assets.
• The cost of illiquidity: Conversely, if a firm holds too little liquidity, it may struggle to pay bills on time, leading to borrowing at high interest rates and jeopardizing its creditworthiness. Low inventory levels may result in lost sales and customer defection, while tight credit policies can further impair sales. The cost of illiquidity rises as current asset levels decrease.