WORKING CAPITAL MANAGEMENT

Involves the relationship between a firm's short-term assets and its short-term liabilities.

The goal of working capital management is to ensure that a firm is able to continue its operations and
that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational
expenses.

The management of working capital involves managing inventories, accounts receivable and payable,
and cash.

Issues in Working Capital Management

Working capital management refers to the administration of all components of working capital cash,
marketable securities, debtors (receivable) and stock (inventories) and creditors (payables). The
financial manager must determine levels and composition of current assets. He must see that right
sources are tapped to finance current assets, and that current liabilities are paid in time.
There are many aspects of working capital management which make it an important function of the
financial manager.

 Time working capital management requires much of the financial manager’s time.
 Investment working capital represents a large portion of the total investment in assets.
 Criticality Working capital represents a large portion of the total investment in assets
 Growth the need for working capital is directly related to the firm’s growth.

Approaches to Financing Current Asset

Depending upon the mix of short and long term financing, the approach followed by a company may be
referred to as,

 matching approach
  conservative approach

 aggressive approach

Matching Approach
When the firm following matching approach (also known as hedging approach), long-term financing will
be used to finance fixed assets and permanent current assets and short-term financing to finance
temporary or variable current assets. However, it should be realized that exact matching is not
possible because of the uncertainty about the expected lives of assets. However, it should be realized
that exact matching is not possible because of the uncertainty about the expected lives of assets.
Figure 3 is used to illustrate the matching plan over time. The firm’s fixed assets and permanent
current assets are financed with long-term funds and as the level of these assets increases, the long-
term financing level also increases. The temporary or variable current assets are financed with short-
term funds and their level increases. The level of short-term financing also increases. Under matching
plan, no short-term financing will be used if the firm has a fixed current assets need only.

Conservative Approach
A firm in practice may adopt a conservative approach in financing its current and fixed assets. The
financing policy of the firm is said to be conservative when it depends more on long-term funds for
financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of
temporary current assets the idle long-term funds can be invested in the tradable securities to
conserve liquidity. The conservative plan relies heavily on long-term financing and, therefore, the firm
has less risk of facing the problem of shortage of funds. The conservative financing policy is shown in
Figure. Note that when the firm has no temporary current assets [e.g., at (a) and (b)]; the long-term
funds released up the liquidity position of the firm.
Aggressive Approach
A firm may be aggressive in financing its assets. An aggressive policy is said to be followed by the firm
when it uses more short-term financing than warranted by the matching plan. Under an aggressive
policy, the firm finances a part of its permanent current assets with short-term financing. Some
extremely aggressive firm may even finance a part of their fixed assets with short-term financing. The
relatively more use of short-term financing makes the firm more risky. The aggressive financing is
illustrated in Figure 5.

COMBINING LIABILITY STRUCTURE AND ASSET MANAGEMENT DECISIONS:

 The level of current assets and the method of financing those assets are interdependent.
 A conservative policy of high level of current assets allows a more aggressive method of
financing current assets.
 A conservative method of financing (All equity) allows an aggressive policy of low levels of
current assets.

CONCEPT OF ZERO WORKING CAPITAL:

Zero working capital is a situation in which there is no excess of current assets over current
liabilities to be funded. The concept is used to drive down the level of investment required to
operate a business, which can also increase the return on investments for shareholders.

Working capital is the difference between current assets and current liabilities, and is primarily
comprised of accounts receivable inventory, and account receivable. The amount of working
capital that a company must invest is usually considerable, and may even exceed its investment in
fixed assets. The amount of working capital will increase as a business increases its credit sales
 since accounts receivable will expand. In addition, inventory levels also increase with sales
growth, as management elects to keep more inventories in stock to support ongoing sales, usually
in the form of additional stock keeping units to meet the needs of customers.

Consequently, a growing business always seems to be short of cash, because its working capital
needs are constantly increasing. In this situation, a company may have an interest in operating
with zero working capital. Doing so requires the following two items:

 Demand-based production. It is nearly impossible to avoid increases in working capital if

management insists on keeping stocks of inventory on hand to meet projected customer needs. To
reduce capital requirements, set up a just in time production system that only builds units when
they are ordered by customers. Doing so eliminates all stocks of finished goods. In addition, install
a just-in-time procurement system that only buys raw materials to support the exact amount of
demand-based units that must be produced. This approach essentially eliminates the investment in
inventory. An alternative approach is to outsource all production, and have the supplier ship goods
directly to the company's customers (known as drop shipping).
 Receivable and payable terms. The terms under which credit is granted to customers must be
curtailed, while payment terms to suppliers must be extended. Ideally, cash should be received
from customers before it is due for payment to suppliers. This essentially means that customer
payments are directly funding the payments to suppliers.

CASH MANAGEMENT:

Cash management is the corporate process of collecting and managing cash, as well as using it for
short-term investing. It is a key component of a company's financial stability and solvency. Corporate
treasurers or business managers are frequently responsible for overall cash management and related
responsibilities to remain solvent.
BREAKING DOWN Cash Management
Cash management involves not only avoiding insolvency, but also reducing the average length account
receivables (AR) are outstanding, increasing collection rates, selecting appropriate short-
term investment vehicles, and increasing cash on hand to improve a company's cash position and
profitability.

Successfully managing cash is an essential skill for small businesses, because they typically have less
access to affordable credit and have a significant amount of upfront costs to manage while waiting for
receivables. Wisely managing cash enables a company to meet unexpected expenses, and to handle
regularly occurring events such as payroll.

Receivables Cash Management

Cash management is the treasury function of a business, responsible for achieving optimal efficiency in
two key areas: receivables, which is cash coming in, and payables, which is cash going out.

When a business issues an invoice it is reported as a receivable, which is cash earned, but not yet to be
received. Depending on the terms of the invoice, the business may have to wait 30, 60 or 90 days for
the cash to be received. It is common for a business to report increasing sales, yet still run into a cash
crunch because of slow or poorly managed receivables. There are a number of things a business can do
to accelerate its receivables and reduce payment float, including clarifying billing terms with
customers, using an automated billing service to bill customers immediately, using electronic payment
processing through a bank to collect payments, and staying on top of collections with a receivables
aging report.

Payables Cash Management

When a business controls its payables, it can better control its cash flow. By improving the overall
efficiency of the payables process, a business can reduce costs and keep more cash working in the
 business. Payables management solutions, such as electronic payment processing, direct payroll
deposit and controlled disbursement, can streamline and automate the payable functions.

Most of the receivables and payables management functions can be automated using business banking
solutions. The digital age has opened up opportunities for smaller businesses to access the same large-
scale cash management technologies used by bigger companies. The cost savings generated from more
efficient cash management techniques easily offsets the costs. More important, management will be
able to reallocate precious resources to growing the business.

Motives for Holding Cash

The Motives for Holding Cash is simple, the cash inflows and outflows are not well synchronized, i.e.
sometimes the cash inflows are more than the cash outflows while at other times the cash outflows
could be more. Hence, the cash is held by the firms to meet the certain as well as uncertain situations.

1. Transaction Motive: The transaction motive refers to the cash required by a firm to meet the day to
day needs of its business operations. In an ordinary course of business, the firm requires cash to make
the payments in the form of salaries, wages, interests, dividends, goods purchased, etc.

Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s cash inflows and
outflows do not match, and hence, the cash is held up to meet its routine commitments.

2. Precautionary Motive: The precautionary motive refers to the tendency of a firm to hold cash, to meet
the contingencies or unforeseen circumstances arising in the course of business.
 Since the future is uncertain, a firm may have to face contingencies such as an increase in the price of
raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet with these
uncertainties, the cash is held by the firms to have uninterrupted business operations.

3. Speculative Motive: The firms hold cash for the speculative purposes to avail the benefit of bargain
purchases that may arise in the future. For example, if the firm feels the prices of raw material are
likely to fall in the future, it will hold cash and wait till the prices actually fall.

Thus, a firm holds cash to exploit the possible opportunities that are out of the normal course of
business. These opportunities could be in the form of the low-interest rate charged on the borrowed
funds, expected fall in the raw material prices or favorable change in the government policies.

Thus, the cash is the most significant and liquid asset that the firm holds. It is significant as it is used to
pay off the firm’s obligations and helps in the expansion of business operations.

Cash receipts:

Cash receipts are the collection of money, typically from a customer, which increases (debits) the cash
balance recognized on a company’s balance sheet.

Also:

A cash receipt is when money is collected from an external source and recorded as an increase to the cash
account.

CASH PAYMENTS:

Cash payments are accounted for by crediting the cash / bank ledger to account for the decrease in the
asset.
MARKETABLE SECURITIES:

Securities or debts that are to be sold or redeemed within a year. These are financial instruments that
can be easily converted to cash such as government bonds, common stock or certificates of deposit.

Marketable securities should be a relatively small figure on the balance sheet of most nonfinancial
companies. Financial companies present marketable securities in a much more prominent place on
their balance sheet since they derive a significant portion of their income from these investments.
Analyst uses this information for liquidity ratio analysis. Creditors are interested in the marketable
securities figure in order to understand what assets are liquid (insert comma) in case the company has
solvency issues. Creditors want to know what they can get a hold of in the event that bankruptcy is
declared.

Inventory management

Is a discipline primarily about specifying the shape and placement of stocked goods. It is required at
different locations within a facility or within many locations of a supply network to precede the regular
and planned course of production and stock of materials.

SCOPE OF INVENTORY MANAGEMENT:

The scope of inventory management concerns the balance between replenishment lead time, carrying
costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility,
future inventory price forecasting, physical inventory, available physical space, quality management,
replenishment, returns and defective goods, and demand forecasting. Balancing these competing
requirements leads to optimal inventory levels, which is an ongoing process as the business needs shift
and react to the wider environment.
Inventory management involves a retailer seeking to acquire and maintain a proper merchandise
assortment while ordering, shipping, handling and related costs are kept in check. It also involves
systems and processes that identify inventory requirements, set targets, provide replenishment
techniques, report actual and projected inventory status and handle all functions related to the tracking
and management of material. This would include the monitoring of material moved into and out of
stockroom locations and the reconciling of the inventory balances. It also may include ABC analysis, lot
tracking, cycle counting support, etc. Management of the inventories, with the primary objective of
determining/controlling stock levels within the physical distribution system, functions to balance the
need for product availability against the need for minimizing stock holding and handling costs.

Special terms used in dealing with inventory management:

STOCK KEEPING UNIT (SKU) SKUs are clear, internal identification numbers assigned to each of the
products and their variants. SKUs can be any combination of letters and numbers chosen, just as long
as the system is consistent and used for all the products in the inventory.

Stock out means running out of the inventory of an SKU.

New old stock (sometimes abbreviated NOS) is a term used in business to refer to merchandise being
offered for sale that was manufactured long ago but that has never been used. Such merchandise may
not be produced anymore, and the new old stock may represent the only market source of a particular
item at the present time.

Inventory cost:

Inventory costs are the costs associated with the procurement, storage and management of inventory.

It includes costs like ordering costs, carrying costs and shortage / stock out costs .
Ordering cost
Refers to the cost incurred for procuring inventory. It includes cost of purchase and the cost of
inbound logistics. In order to minimize the ordering cost of inventory we make use of the concept of
EOQ or Economic Order Quantity.

Carrying cost
Refers to the cost incurred towards inventory storage and maintenance. The inventory storage costs
typically include the cost of building rental and other infrastructure maintained to preserve inventory.
The inventory carrying cost is dependent upon and varies with the decision of the management to
manage inventory in house or through outsourced vendors and third party service providers.

Shortage or stock out

Costs and cost of replenishment are the costs incurred in unusual circumstances. They usually form a
very small part of the total inventory cost.

INVENTORY CONTROLL SYSTEM:

An inventory control system is a system the encompasses all aspects of managing a company's
inventories; purchasing, shipping, receiving, tracking, warehousing and storage, turnover, and
reordering. In different firms the activities associated with each of these areas may not be strictly
contained within separate subsystems, but these functions must be performed in sequence in order to
have a well-run inventory control system. Computerized inventory control systems make it possible to
integrate the various functional subsystems that are a part of the inventory management into a single
cohesive system.
RECEIVABLE MANAGMENT

An account receivable management incorporates is all about ensuring that customers pay their
invoices. Good receivables management helps prevent overdue payment or non-payment. It is therefore
a quick and effective way to strengthen the company's financial or liquidity position.

CREDIT COLLECTION POLICY

A credit collections policy is a document that includes “clear, written guidelines that set the terms and
conditions for supplying goods on credit, customer qualification criteria, procedure for making
collections, and steps to be taken in caseofcustomerdelinquency”.
In fewer words, it is a guide offering an organized and repeatable philosophy on selling on the rules,
regulations and procedures to manage daily operations. The goal for a credit collections plan is to
clearly define these elements so that sales and collections employees conform to documented steps and
procedures designed to optimize your resources, reduce credit risk, and improve overall cash flow.

A well written and comprehensive credit collection policy will:

 Ensure continuity in the department in the event that key personnel leave the credit
department.
 Help make sure all customers are treated fairly.
 Ensure consistent credit decisions are being made.
 Be used as a training tool for new sales associates and the credit and collections team.
 Be used to ensure consistency of procedure and execution between the credit department,
sales, and management.
 CREDIT PERIOD

The credit period is the number of days that a customer is allowed to wait before paying
an invoice. The concept is important because it indicates the amount of working capital that a
business is willing to invest in its accounts receivable in order to generate sales. Thus, a longer
credit period equates to a larger investment in receivables. The measure can also be compared to
the credit period of competitors, to see if other companies are offering different terms to their
customers. For example:

 If the company grants terms of 2/10 net 30, this means the credit period is 10 days if the
customer chooses to take a 2% early payment discount, or the credit period is 30 days if the
customer chooses to pay the full amount of the invoice.
 If the company grants terms of 1/5 net 45, this means the credit period is 5 days if the customer
chooses to take a 1% early payment discount, or the credit period is 45 days if the customer
chooses to pay the full amount of the invoice.

The credit period does not refer to the amount of time that the customer takes to pay an invoice,
but rather to the period granted by the seller in which to pay the invoice. Thus, if the seller allows
30 days in which to pay and the customer pays in 40 days, the credit period was only 30 days.

CREDIT STANDARDS

The term credit standard represents the basic criteria for the extension of the credit to customers. If
the credit standard of the organization is the right one there will not any debt losses and less cost of
credit administration.

SHORT TERM FINANCING

Short term finance refers to financing needs for a small period normally less than a year. In
businesses, it is also known as working capital financing. This type of financing is normally needed
because of uneven flow of cash into the business, the seasonal pattern of business, etc. In most cases,
it is used to finance all types of inventory, accounts receivables etc. At times, only specific one time
orders of business are financed.

TYPES

 TTRADE CREDIT
 SHORT TERM LOANS
 BUSINESS LINE OF CREDIT
 INVOICE DISCOUNTING
 FACTORING

Alternative Current Asset Financing Policies

Most businesses experience seasonal and/or cyclical fluctuations. For example, construction firms
have peaks in the spring and summer, retailers peak around Christmas and the manufacturers who
supply both construction companies and retailers follow similar patterns. The manner in which the
permanent and temporary current assets are financed is called the firm’s current asset financing
policy.

Maturity Matching, or “Self-Liquidating”, Approach

The maturity matching, or “self-liquidating”, approach calls for matching asset and liability maturities.
This strategy minimizes the risk that the firm will be unable to pay off its maturing obligations. To
illustrate, suppose a company borrows on a one year basis and uses the funds obtained to build and
equip a plant. Cash flows from the plant (profits plus depreciation) would not be sufficient to pay off the
loan at the end of only one year, so the loan would have to be renewed. If for some reason the lender
refused to renew the loan, then the company would have problems.

Aggressive Approach

Relatively aggressive firm which finances all of its fixed assets with long-term capital and part of its
permanent current assets with short-term, no spontaneous credit. Note that we used the term
“relatively” in the title for panel b because there can be different degrees of aggressiveness. For
example, the dashed line in panel b could have been drawn below the line designating fixed assets,
indicating that all of the permanent current assets and part of the fixed assets were financed with
short-term credit; this would be a highly aggressive, extremely neoconservative position and the firm
would be very much subject to dangers from rising interest rates as well as to loan renewal problems.
However, short-term debt is often cheaper than long-term debt, and some firms are willing to sacrifice
safety for the chance of higher profits.

Conservative Approach

Current assets indicating that permanent capital are being used to finance all permanent asset
requirements and also to meet some of the seasonal needs. In this situation, the firm uses a small
amount of short-term, no spontaneous credit to meet its peak requirements, but it also meets a part of
its seasonal needs by “storing liquidity” in the form of marketable securities. The humps above the
dashed line represent short-term financing, while the troughs below the dashed line represent short-
term security holdings. Panel c represents a very safe, conservative current asset financing policy.

Pros Cons
Generally Easy Approval Process Higher Interest Rates & Frequent Payments
Increased Cash Flow The Risk of Being Sucked into a Debt Cycle
Access to Opportunities No access to opportunities