Chapter 01

Introduction to the
Management of Working Capital
Textbook Name: Modern Working
Capital Management: Text and Cases
Author: Frederick C. Scherr
Edition: Latest
Publisher: Prentice-Hall International
Introduction

● The financial management of business firms involves three

functions:

● The management of long-term assets (capital budgeting)

● The management of long-term capital (capital structure)
● The management of short-term assets and liabilities (working
capital management)
BALANCE SHEET
What is Working Capital?
● The cash a business requires for day-to-day operations, or, more
specifically, for financing the conversion of raw materials into
finished goods, which the company sells for payment.

● Among the most important items of working capital are –

✔ Levels of inventory,

✔ Accounts receivable, and

✔ Accounts payable.
What is Working Capital?
● The working capital is calculated as:
Working Capital = Current Assets – Current Liabilities.

● Positive working capital means that the company is able to pay

off its short-term liabilities.

● Negative working capital means that a company currently is

unable to meet its short-term liabilities with its current assets.
What is Working Capital?
● The working capital is calculated as:
Working Capital = Current Assets – Current Liabilities.

BDT

BDT

BDT
What is Working Capital?
● Current Assets include:
● Stock or inventory (raw
materials + work-in
progress + finished
goods)
● Accounts receivables
● Cash in hand
● Short-term securities
● Current Liabilities include:
● Money owing to trade
creditors (mainly for raw
materials)
● Bank overdrafts
● Other short-term loans
● Outstanding tax, dividend
and interest obligations
What is Working Capital?
● Company's current assets do not exceed its current liabilities
→ Run into trouble paying back creditors in the short term.
● The worst-case scenario is bankruptcy.

● A declining working capital ratio over a longer time

period could also be a red flag that warrants further analysis.

● For example, it could be that the company's sales volumes are

decreasing, and as a result, its accounts receivables number
continues to get smaller and smaller.
What is Working Capital?
● Working capital is a measure of a company's efficiency and its
short-term financial health.

● For example,
● If a company is not operating in the most efficient manner (slow A/R
collection), it will show up as an increase in the working capital.
● This can be seen by comparing the working capital from one period to
another; slow collection may signal an underlying problem in the
company's operations.
What is Working Capital Management?
● Managerial accounting strategy focusing on
maintaining efficient levels of both components of working
capital (current assets and current liabilities) in respect to
each other.
● Ensures a company has sufficient cash flow in order to meet its
short-term debt obligations and operating expenses.
● Key performance ratios of a WCM system are: working capital
ratio, inventory turnover and the collection ratio. These ratio
analysis will lead management to identify areas of focus such as
cash management, A/R management, inventory management, and
A/P management.
What is Working Capital Management?
● A few key performance ratios of a WCM system are:
Working capital ratio,
Inventory turnover and
Collection ratio.

● These ratio analysis will lead management to identify

areas of focus such as cash management, accounts
receivable management, inventory management, and
account payable management.
What is Working Capital Management?

● The management of working capital is concerned with the

management of the assets and liabilities in the top half of
the balance sheet.
● We will analyze decisions such as:
● How should the firm manage its cash?

● To whom should the firm grant credit?

● How much inventory should the firm keep?

● What should be the composition of the firm’s current debt?

Objectives of Working Capital Management

● The two main aims to be satisfied by the working capital

manager are profitability and liquidity.
● Investments, in current as well as long-term assets,
should be undertaken if they will offer the most
satisfactory returns to shareholders – measured by
net present values discounted at the cost of capital.
● The goal of liquidity is designed to ensure that the firm
can satisfy its financial obligations and continue as a
going concern.
Objectives of Working Capital Management

● The two goals of profitability and liquidity frequently conflict

with one another. Attempts to produce the maximum
profitability out of the various elements of the working
capital can create severe liquidity problems. At the same
time, over-concentration on liquidity can water down profits.

● A major function of decision making for working capital is the

management of the various working capital accounts with regard
to the firm’s level of liquidity:
NOT TOO MUCH LIQUIDITY AND NOT TOO LITTLE
LIQUIDITY.
Objectives of Working Capital Management

● Management means establishing the best possible trade-off

between the profitability of the net current assets employed and
the ability to pay current liabilities as they fall due.
● This latter implies a clearly defined risk policy to determine the
required liquidity level.
Importance of Working Capital Management
● There would be no need of holding cash for working capital other
than for the initial costs, because it could be possible to make
the payment from every receipt of sales.

● Likewise, there would also be no need for receivables and

payables if customers pay cash immediately and the firm
would also make its payments promptly.
Importance of Working Capital Management
● However, problems of working capital exist because these ideal
assumptions are never realistic and therefore working capital
levels make a significant part of a firm’s investment in assets and
these assets have to be financed implying that investments may
have benefits as well as costs.
Importance of Working Capital Management
● Implementing an effective working capital management
system is an excellent way for many companies to improve
their earnings.
● Working capital consists of a large portion of a firm’s total
investment in assets. It amounts usually to 40 percent in
manufacturing industries and 50% - 60% in retailing and
wholesales (Moyer, Mcguigan and Kretlow, 1995).
Importance of Working Capital Management
● By minimizing the amount of funds tied up in current
assets, firms are able to reduce financing costs and/or
increase the funds available for expansion.
● Therefore, the importance of efficient working capital
management is indisputable in business.
Importance of Working Capital Management

● By implementing best practices in working capital, companies

can strengthen strong cash flow levels, improve
profitability, budgeting and forecasting process,
predictability and manageability of results, heighten risk visibility
and reduce reaction time.
● Scherr (1989) considering the importance of WC found that
managers spend much of their time in activities directly or
indirectly related to working capital investments and short-term
debts. Survey evidence shows that 60% of a financial manager’s
time is spent on decisions related to working capital management.
Importance of Working Capital Management
● The management of working capital plays an important role in
maintaining the financial health of the firm during the normal
course of business.
● Besides this basic and continuing reason for the importance of
working capital management to the firm, several developments
in the late 1970s and early 1980s led to increasing concern for
the management of these accounts.
Importance of Working Capital Management
● For example, level of interest rates that climbed extremely high
by historic standards, caused the financing of investments to
become more costly. Deregulated money markets provided
financial managers with access to many instruments for
short-term financing and investment.
● Together, these developments kept corporate treasurers
seeking new and better ways of managing individual working
capital accounts to balance the firm’s overall liquidity position.
 Managing Working Capital Crisis

● Present-day industrial organizations are confronted more and

more with a shortage of working capital with which to run
their units at an economical level of operation.
● With the ever increasing rate of inflation, associated with an
increase in the cost of capital and more demands for
resources due to rapid industrialization, with a consequent credit
squeeze policy adopted by the banks and financial institutions, the
management of working capital has assumed great significance
recently.
 Managing Working Capital Crisis

● In many organizations the technology adopted may not be so

advanced, resulting in lower operational efficiency, uneconomical
costs and a longer manufacturing cycle time.
● The working capital needs of an organization depend on a
multitude of factors, such as operating level, level of operational
efficiency, service level, inventory policies, book debt policies, etc.
● Financing is based on the extent of internal cash generation,
the availability of credit limits, the relative cost
effectiveness of different sources of financing, etc.
 Formulating Appropriate Strategies

● To tide the organization over the working capital crisis and to

further improve its financial position some short- and
long-term strategies need to be adopted.
● Short-term strategies should meet the immediate challenge of
the working capital crisis. However, the scope of such strategies
may be restricted.
● To manage working capital more effectively, long-term
strategies may have to be adopted to reduce the working
capital needs of the organization, to increase its level of
operation and, consequently, to generate more and more
funds, to finance working capital requirements.
Short-Term Strategies

● Gearing up collection efforts by adopting more stringent follow

up methods, offering discount to the customers against
prompt payment.
● Restricting credit policy
● Operating more and more with customers‘ materials, thereby
reducing the inventory level
● Slashing developmental expenditure over the short-term —
cutting back on its R&D budget, training and development budget
or product promotional expenditure, etc.
● Negotiating with the creditors like deferring payment to
creditors, converting the loan into equity, etc.
Long-Term Strategies
● Reducing the working capital needs
● Reducing the inventory holding requirement
● R&D efforts leading to improved operational efficiency
● Cost reduction through higher capacity utilization
● Improving capacity utilization
● Removing input constraints
● Plant modernization and improvement for higher plant
availability
● Capacity expansion
● Quality control efforts
● Product promotion
 Working Capital Management Practices
in Bangladesh
● There are a few studies on working capital management in
Bangladesh covering both public and private sectors including
several multinational companies (MNCs).
● Mohiuddin (1983) has conducted a study on cash budget and
concluded that effective cash budgeting minimizes the liquidity
problems.
● Islam and Rahman (1994) have identified the working capital
trends of some selected enterprises in Bangladesh.
 Working Capital Management Practices
in Bangladesh
● Sayaduzzaman (2006) has conducted study on British American
Tobacco Bangladesh Company Ltd. and found that the working
capital management practices of the company is highly
satisfactory due to efficient management of inventory, debtors,
cash balances and working funds.
● Chowdhury and Amin (2007) has conducted a study on
pharmaceutical industry and concluded that pharmaceutical firms
operated in Bangladesh are efficiently deal with their liquidity
preferences and investment criteria and this is due to the
competitive nature of this industry.
 Working Capital Management Practices
in Bangladesh
● The studies conducted in Bangladesh on working capital
management is either company specific (Islam and Rahman, 1994;
Sayaduzzaman, 2006) or at best industry specific (Zaman, 1976;
Zaman, 1991b; Zaman, 1991c; Chowdhury and Amin, 2007).
● There is no such study of evaluating working capital management
performances of a large sample of manufacturing ventures in
Bangladesh.
● One such study has been conducted by Siddiquee and Khan (2009)
covering 83 companies (total 414 observations) from different
sectors enlisted with the Dhaka Stock Exchange (DSE) Ltd. during
the stipulated period of 2003-2007.
 Working Capital Management Practices
in Bangladesh
● Another study on the working capital management practices,
commissioned by Siddiquee and Hossain (2009) is underway
covering a large sample size of 243 manufacturing companies
from different sectors.
● The sample includes companies from the sectors: Cement,
Ceramics, Engineering, Food and Allied, Fuel & Power, ICT, Jute,
Leasing, Leather, Miscellaneous, Paper & Packaging,
Pharmaceuticals & Chemicals, Services & Real Estate, and Textile.