Overview of Working Capital and its Planning & Management

Table of Contents

1. Introduction
2. The Operating Cycle and Working Capital Needs
3. Factors Determining Working Capital Requirement
4. Need For Adequate Working Capital
5. Working Capital Policy and Management
6. Financing of Current Assets
7. Working Capital Monitoring and Control
8. Points to Remember

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“Working Capital, also called net current assets, is the excess of current assets over current liabilities. All organizations have to carry working capital in one form or the other. The efficient management of working capital is important from the point of view of both liquidity and profitability. Poor management of working capital means that funds are unnecessarily tied up in idle assets hence reducing liquidity and also reducing the ability to invest in productive assets such as plant and machinery, so affecting the profitability.”

1. Introduction

The working capital management refers to management of the working capital, or to be more precise, the management of current assets. A firm’s working capital consists of its investment in current assets which include short term assets such as cash and bank balance, inventories, receivables (including debtors and bills), and marketable securities. Working capital management refers to the management of the level of all these individual current assets. The need for working capital management arises from two considerations. First, existence of working capital is imperative in any firm. The fixed assets which usually require a large chunk of total funds, can be used at an optimum level only if supported by sufficient working capital, and second, the working capital involves investment of funds of the firm. If the working capital level is not properly maintained and managed, then it may result in unnecessary blocking of scarce resources of the firm. The insufficient working capital, on the other hand, put different hindrances in smooth working of the firm. Therefore, the working capital management needs attention of all the financial managers.

The working capital management includes the management of the level of individual current assets as well as the management of total working capital. However, each individual current assets has unique characteristics which the financial manager must consider in deciding how much money should be invested in each of these current assets. In other words, he must decide the level of all the current assets. The management of individual current assets i.e., cash and bank balance, marketable securities, receivables and inventories has been taken up in subsequent chapters. However, the general principles of working capital management have been taken up in this chapter.

1.1 Nature and Types of Working Capital

The term working capital refers to current assets which may be defined as (i) those which are convertible into cash or equivalents within a period of one year, and (ii) those which are required to meet day to day operations. The fixed assets as well as the current assets, both requires investment of funds. So, the management of working capital and of fixed assets, apparently, seem to involve same types of considerations but it is not so.

The management of working capital involves different concepts and methodology than the techniques used in fixed assets management. The reason for this difference is obvious. The very basics of fixed assets decision process (i.e., the capital budgeting) and the working capital decision process are different. The fixed assets involve long period perspective and therefore, the concept of time value of money is applied in order to discount the future cash flows; whereas in working capital the time horizon is limited, in general, to one year only and the time value of money concept is not considered. The fixed assets affect the long term profitability of the firm while the current assets affect the short term liquidity position. The fixed assets decisions, as already discussed in Chapter 8, are irreversible and affect the growth of the firm, whereas the working capital decisions can be changed and modified without much implications.

Managing current assets may require more attention than managing fixed assets. The financial manager cannot simply decide the level of the current assets and stop there. The level of investment in each of the current assets varies from day to day, and the financial manager must therefore, continuously monitor these assets to ensure that the desired levels are being maintained. Since, the amount of money invested in current assets can change rapidly, so does the financing required. Mis-management of current assets can be costly. Too large an investment in current assets means tying up funds that can be productively used elsewhere (or it means added interest cost if the firm has borrowed funds to finance the investment in current assets). Excess investment may also expose the firm to undue risk e.g., in case, the inventory cannot be sold or the receivables cannot be collected.

On the other hand, too little investment also can be expensive. For example, insufficient inventory may mean that sales are lost as the goods which a customer wants are not available. The result is that the financial managers spend a large chunk of their time managing the current assets because level of these assets changes quickly and a lack of attention paid to them may result in appreciably lower profits for the firm. So, in the working capital management, a financial manager is faced with a decision involving some of the considerations as follows:

1. What should be the total investment in working capital of the firm?
2. What should be the level of individual current assets?
3. What should be the relative proportion of different sources to finance the working capital requirements?

Thus, the working capital management may be defined as the management of firm’s sources and uses of working capital in order to maximize the wealth of the shareholders. The proper working capital management requires both the medium term planning (say up to three years) and also the immediate adaptations to changes arising due to fluctuations in operating levels of the firm.

The term working capital may be used in two different ways:

(i) Gross Working Capital (or Total Working Capital)

The gross working capital refers to the firm’s investment in all the current assets taken together. The total of investments in all the individual current assets is the gross working capital. For example, if a firm has a cash balance of ` 50,000, debtors of ` 70,000 and inventory of raw material and finished goods has been assessed at ` 1,00,000, then the gross working capital of the firm is ` 2,20,000 (i.e., `50,000 + `70,000 + ` 1,00,000).

(ii) Net Working Capital

The term net working capital may be defined as the excess of total current assets over total current liabilities. It may be noted that the current liabilities refer to those liabilities which are payable within a period of 1 year. The extent, to which the payments to these current liabilities are delayed, the firm gets the availability of funds for that period. So, a part of the funds required to maintain current assets is provided by the current liabilities and the firm will be required to invest the funds in only those current assets which are not financed by the current liabilities.

The net working capital may either be positive or negative. If the total current assets are more than total current liabilities, then the difference is known as positive net working capital, otherwise the difference is known as negative net working capital. The net working capital measures the firm’s liquidity. The greater the margin (i.e., net working capital) by which the firm’s current assets cover its current liabilities, the better will it be. Although the firm’s current assets may not be converted into cash precisely when they are needed, still greater net working capital assures that in all likelihood some current assets will be converted into cash to pay the current liabilities.

The distinction between gross working capital and net working capital does not in any way undermine the relevance of the concepts of either gross or net working capital. A financial manager must consider both of them because they provide different interpretations. The gross working capital denotes the total working capital or the total investment in current assets. A firm should maintain an optimum level of gross working capital. This will help avoiding

(i) the unnecessarily stoppage of work or chance of liquidation due to insufficient working capital, and

(ii) effect on profitability (because over flowing working capital implies cost).

Therefore, a firm should have just adequate level of total current assets. The gross working capital also gives an idea of total funds required for maintaining current assets.

On the other hand, net working capital refers to the amount of funds that must be invested by the firm, more or less, regularly in current assets. The remaining portion of current assets being financed by the current liabilities. The net working capital also denotes the net liquidity being maintained by the firm. This also gives an idea of buffer available to the current liabilities.

Both concepts of working capital i.e., the gross working capital and the net working capital have their own relevance and a financial manager should give due attention to both of these.

2. The Operating Cycle and Working Capital Needs

The working capital requirement of a firm depends, to a great extent upon the operating cycle of the firm. The operating cycle may be defined as the time duration starting from the procurement of goods or raw materials and ending with the sales realization. The length and nature of the operating cycle may differ from one firm to another depending upon the size and nature of the firm.

In a trading concern, there is a series of activities starting from procurement of goods (saleable goods) and ending with the realization of sales revenue (at the time of sale itself in case of cash sales and at the time of debtors realizations in case of credit sales). Similarly, in case of manufacturing concern, this series starts from procurement of raw materials and ending with the sales realization of finished goods (after going through the different stages of production). In both the cases, however, there is a time gap between the happening of the first event and the happening of the last event. This time gap is called the Operating Cycle.

Thus, the operating cycle of a firm consists of the time required for the completion of the chronological sequence of some or all of the following:

• Procurement of raw materials and services.
• Conversion of raw materials into work-in-progress.
• Conversion of work-in-progress into finished goods.
• Sale of finished goods (cash or credit).
• Conversion of receivables into cash.

These activities create and necessitate cash flows which are neither synchronized nor certain. The relevant cash flows are not synchronized because the cash disbursements (i.e., payment for purchases) take place before the cash inflows (from sales realizations). These cash flows are uncertain because these depend upon the future costs and sales. Of course, the cash outflows relating to payment for purchases and payment for wages and other expenses are less uncertain with respect to time as well as quantum. What is required on the part of a firm is to make adjustments and arrangements so that the uncertainty and unsynchronization of these cash flows can be taken care of.

The firm is often required to extend credit facilities to customers. The finished goods must be kept in store to take care of the orders and a minimum cash balance must be maintained. It must also have a minimum of raw materials to have smooth and uninterrupted production process. So, in order to have a proper and smooth running of the business activities, the firm must make investments in all these current assets. This requirement of funds depends upon the operating cycle period of the firm and is also denoted as the working capital needs of the firm.

2.1 Operating Cycle Period

The length or time duration of the operating cycle of any firm can be defined as the sum of its inventory conversion period and the receivable conversion period.

(i) Inventory Conversion Period (ICP)

It is the time required for the conversion of raw materials into finished goods sales. In a manufacturing firm the ICP is consisting of Raw Material Conversion Period (RMCP), Work-in-Progress Conversion Period (WPCP), and the Finished Goods Conversion Period (FGCP). The RMCP refers to the period for which the raw material is generally kept in stores before it is issued to the production department. The WPCP refers to the period for which the raw materials remain in the production process before it is taken out as a finished unit. The FGCP refers to the period for which finished units remain in stores before being sold to the customers.

(ii) Receivables Conversion Period (RCP)

It is the time required to convert the credit sales into cash realization. It refers to the period between the occurrence of credit sales and collection of debtors.

Cycle Period (TOCP). The firm might be getting some credit facilities from the supplier of raw materials, wage earners etc. The period for which the payments to these parties are deferred or delayed is known as Deferral Period (DP). The Net Operating Cycle (NOC) of the firm is arrived at by deducting the DP from the TOCP. Thus,

The operating cycle of a firm has been shown in Figure 12.1.

For calculation of TOCP and NOC, various conversion periods may be calculated as follows:

In respect of these formulations, the following points are worth noting :

1. The ‘Average’ value in the numerator is the average of opening balance and closing balance of the respective item. However, if only the closing balance is available, then even the closing balance may be taken as the ‘Average’.
2. The figure ‘365’ represents number of days in a year. However, there is no hard and fast rule and sometimes even 360 days are considered.
3. The ‘Total’ figure in the denominator refers to the total value of the item in a particular year, and
4. In the calculation of RMCP, WPCP, and FGCP, the denominator is calculated at cost-basis and the profit margin has been excluded. The reason being that there is no investment of funds in profit as such.

On the basis of above conversion periods, the TOCP and NOC may be ascertained as follows :

The TOCP and NOC do not measure the absolute amount of funds invested in working capital. However, a longer NOC will generally indicate a requirement for more working capital. Lesser amount of working capital will be required at the beginning of the operating cycle than at the end because most of the expenses are incurred well after initial raw materials are procured and introduced in the production process. The operating cycle for an individual component keeps on changing from time to time, particularly the RCP and the DP. Therefore, a regular attention and review is required. It would be extremely difficult to determine an optimum operating cycle for a particular firm. The comparison of firm’s operating cycle for a period with that of the previous period and with that of the operating cycle of other firms may help in maintaining and controlling the length of the operating cycle.

3. Factors Determining Working Capital Requirement

The working capital needs of a firm are determined and influenced by various factors. A wide variety of considerations may affect the quantum of working capital required and these considerations may vary from time to time. The working capital needed at one point of time may not be good enough for some other situation. The determination of working capital requirement is a continuous process and must be undertaken on a regular basis in the light of the changing situations. Following are some of the factors which are relevant in determining the working capital needs of the firm :

1. Basic Nature of Business: The working capital requirement is closely related to the nature of the business of the firm. In case of a retail shop or a trading firm, the amount of working capital required is small enough. Most of the transactions are undertaken in cash and the length of the operating cycle is generally small. The trading concerns usually have smaller needs of working capital, however, in certain cases, large inventories of goods may be required and consequently the working capital may be large. In case of financial concerns (engaged in financial business) there may not be stock of goods but these firms do have to maintain sufficient liquidity all the times. In case of manufacturing concerns, different types of production processes are performed. One unit of raw material introduced in the production schedule may take a long period before it is available as finished goods for sale. Funds are blocked not only in raw materials but also in labour expenses and overheads at every stage of production. So, in case of manufacturing concerns, there is a requirement of substantial working capital.
2. Business Cycle Fluctuations: Different phases of business cycle i.e., boom, recession, recovery etc. also affect the working capital requirement. In case of boom conditions, inflationary pressure appears and business activities expand. As a result, the overall need for cash, inventories etc. increases resulting in more and more funds blocked in these current assets. In case of recession period however, there is usually a dullness in business activities and there will be an opposite effect on the level of working capital requirement. There will be a fall in inventories and cash requirement etc.
3. Seasonal Operations: If a firm is operating in goods and services having seasonal fluctuations in demand, then the working capital requirement will also fluctuate with every change. In a cold drink factory, the demand will certainly be higher during summer season and therefore, more working capital is required to maintain higher production, in the form of larger inventories and bigger receivables. On the other hand, if the operations are smooth and even throughout the year then the working capital requirement will be constant and will not be affected by the seasonal factors.
4. Market Competitiveness: The market competitiveness has an important bearing on the working capital needs of a firm. In view of the competitive conditions prevailing in the market, the firm may have to offer liberal credit terms to the customers resulting in higher debtors. Even larger inventories may be maintained to serve an order as and when received; otherwise the customer may go to some other supplier. Thus, the working capital tends to be high as a result of greater investment in inventories and receivables. On the other hand, a monopolistic firm may not require larger working capital. It may ask the customers to pay in advance or to wait for some time after placing the order.
5. Credit Policy: The credit policy means the totality of terms and conditions on which goods are sold and purchased. A firm has to interact with two types of credit policies at a time. One, the credit policy of the supplier of raw materials, goods etc., and two, the credit policy relating to credit which it extends to its customers. In both the cases, however, the firm while deciding its credit policy, has to take care of the credit policy of the market. For example, a firm might be purchasing goods and services on credit terms but selling goods only for cash. The working capital requirement of this firm will be lower than that of a firm which is purchasing cash but has to sell on credit basis.
6. Supply Conditions: The time taken by a supplier of raw materials, goods etc. after placing an order, also deter mines the working capital requirement. If goods are received as soon as or in a short period after placing an order, then the purchaser will not like to maintain a high level of inventory of that goods. Otherwise, larger inventories should be kept e.g., in case of imported goods. It is often seen that the shopkeepers may not be keeping stock of all items, but whenever there is a demand, they procure from the wholesaler/producer and supply it to their customers.

Thus, the working capital requirement of a firm is determined by a host of factors. Every consideration is to be weighted relatively to determine the working capital requirement. Further, the determination of working capital requirement is not once a while exercise, rather a continuous review must be made in order to assess the working capital requirement in the changing situation. There are various reasons which may require the review of the working capital requirement e.g., change in credit policy, change in sales volume, etc.

4. Need For Adequate Working Capital

The need and importance of adequate working capital for day to day operations can hardly be underestimated. Every firm must maintain a sound working capital position otherwise, its business activities may be adversely affected. The financial manager must see that the firm has sufficient working capital as and when required so that the fixed assets of the firm are optionally used. The objective of financial management i.e., to maximize the wealth of the shareholder cannot be attained if the operations of the firm are not optimized. Thus, every firm must have adequate working capital. It should have neither the excessive working capital nor inadequate working capital. Both situations are risky and may have dangerous outcome. The excessive working capital, when the investment in working capital is more than the required level, may result in

• Unnecessary accumulation of inventories resulting in waste, theft, damage etc.
• Delays in collection of receivables resulting in more liberal credit terms to customers than warranted by the market conditions.
• Adverse influence on the performance of the management.

On the other hand, inadequate working capital situation, when the firm does not have sufficient working capital to support its operations, is also not good for the firm. Such a situation may have following consequences:

(i) The fixed assets may not be optimally used.

(ii) Firms growth may stagnate.

(iii) Interruptions in production schedule may occur ultimately resulting in lowering of the profit of the firm.

(iv) The firm may not be able to take benefit of an opportunity.

(v) Firm’s goodwill in the market is affected if it is not in a position to meet its liabilities on time.

In view of the above, it can be said that the management of a firm in general and the financial manager in particular, must understand the importance of adequate working capital. In other words, the working capital level of a firm must be maintained and managed at an appropriate level. The financial manager must establish (i) a well defined working capital policy and (ii) a self sufficient working capital management system. While designing the working capital policy, the financial manager should take care of the following aspects:

• What should be the level of total and individual current assets in view of the expected sales level?
• The financing pattern of the total working capital needs.

The working capital system should be established to take care of management of all aspects of the current assets. Efforts should be made to establish a built-in internal control system to take note of the level as well as fluctuations in all components of the working capital. Different aspects of working capital policy and management have been discussed in the following section.

5. Working Capital Policy and Management

The working capital management includes and refers to the procedures and policies required to manage the working capital. It may be noted that the long term profitability of a firm, undoubtedly, depends upon the investment decisions of a firm. The investment decisions determine the pattern of sales growth and sales in turn, determine the profitability. However, the investment decisions and other decisions have two important implications for working capital management. First, the sales forecast of goods and services being produced by the firm allow the financial manager to estimate the working capital needs and level of different current assets. Second, the working capital management helps maximizing the shareholders wealth by providing and maintaining firm’s liquidity. The working capital management need not necessarily have a target of increasing the wealth of the shareholders, nevertheless it helps attaining the objective by providing sufficient liquidity to the firm.

The importance of working capital management, thus, can be expressed in terms of the following points :

• The level of current assets changes constantly and regularly depending upon the level of actual and forecasted sales. This requires that the decisions to bring a level of current assets to the desired levels of current assets should be made at the earliest opportunity and as frequently as required.
• The changing levels of current assets may also require review of the financing pattern. How much working capital needs to be financed by different sources of financing must be periodically reviewed.
• Inefficient working capital management may result in loss of sales and consequently decline in profits of the firm.
• Inefficient working capital management may also lead to insolvency of the firm if it is not in a position to meet its liabilities and commitments.
• Current assets usually represent a substantial portion of the total assets of the firm, resulting in investment of a larger chunk of funds in the current assets.
• There is an obvious and inevitable relationship between the sales growth and the level of current assets. The target sales level can be achieved only if supported by adequate working capital. The increase in sales level requires increase in working capital and thus the financial manager must be able to respond quickly in providing and arranging additional working capital.

Thus, the efficient working capital management is important from the point of view of both the liquidity and the profitability. Poor and inefficient working capital management means that funds are unnecessarily tied up in idle assets. This reduces the liquidity as well as the ability to invest funds in productive assets, so affecting the profitability. Keeping in view the importance of working capital management, the financial manager should look into the framing of a suitable working capital policy for the firm. Following are some of the important aspects of a working capital policy.

5.1 Determining the Ratio of Current Assets to Sales

As already said that there is an inevitable relationship, between the sales and the current assets. The actual and the forecasted sales have a major impact on the amount of current assets which the firm must maintain. So, depending upon the sale forecast, the financial manager should also estimate the requirement of current assets. However, as the sales forecast cannot be certain, so is the case with the forecast of current assets also. This uncertainty may result in spontaneous increase in current assets in line with the increase in sales level, and may bring the firm to face tight working capital position. In order to overcome this uncertainty, the financial manager may establish a minimum level as well as a safety component for each of the current assets for different levels of sales. But how much should be this safety component? It may be noted that in fact, this safety component determines the type of working capital policy a firm is pursuing. There are three types of working capital policies which a firm may adopt i.e., moderate working capital policy, conservative working capital policy and aggressive working capital policy. These policies describe the relationship between sales level and the level of current assets and have been shown in Figure 12.2.

Figure 12.2 shows that in case of moderate working capital policy, the increase in sales level will be coupled with proportionate increase in level of current assets also e.g., if the sales increase or are expected to increase by 10%, then the level of current assets will also be increased by 10%. In case of conservative working capital policy, the firm does not like to take risk. For every increase in sales, the level of current assets will be increased more than proportionately. Such a policy tends to reduce the risk of shortage of working capital by increasing the safety component of current assets. The conservative working capital policy also reduces the risk of non-payment to liabilities.

On the other hand, a firm is said to have adopted an aggressive working capital policy if the increase in sales does not result in proportionate increase in current assets. For example, for 10% increase in sales the level of current assets is increased by 7% only. This type of aggressive policy has many implications. First, the risk of insolvency of the firm increases as the firm maintains lower liquidity. Second, the firm is exposed to greater risk as it may not be able to face unexpected change market and, third, reduced investment in current assets will result in increase in profitability of the firm.

5.2 Liquidity v. Profitability – A Risk-Return Trade-off

Another important aspect of a working capital policy is to maintain and provide sufficient liquidity to the firm. Like most corporate financial decisions, the decision on how much working capital be maintained involves a trade-off because having a large net working capital may reduce the liquidity-risk faced by the firm, but it can have a negative effect on the cash flows. Therefore, the net effect on the value of the firm should be used to determine the optimal amount of working capital. A firm must maintain enough cash balance or other liquid assets so that it never faces problems of payment to liabilities. Does it mean that a firm should maintain unnecessarily large liquidity to pay the creditors? Can a firm adopt such a policy? Certainly not. There is also another side of the coin. Greater liquidity makes the firm meeting easily its payment commitments, but simultaneously greater liquidity involves cost also.

The risk-return trade-off involved in managing the firm’s working capital is a trade-off between the firm’s liquidity and its profitability. By maintaining a large investment in current assets like cash, inventory, etc., the firm reduces the chances of (i) production stoppages and the lost sales from the inventory shortages, and (ii) the inability to pay the creditors on time. However, as the firm increases its investment in working capital, there is not a corresponding increase in its expected returns. This means that the firm’s return on investment drops because the profit are unchanged while the investment in current assets increases.

In addition to the above, the firm’s use of current liability versus long term debt also involves a risk-return trade-off. Other things being equal, the greater the firm’s reliance on the short term debts or current liabilities in financing its current assets, the greater the risk of illiquidity. On the other hand, the use of current liability can be advantageous as it is less costly and flexible means of financing. A firm can reduce its risk of illiquidity through the use of long term debts at the cost of reduction in its return on investment. The risk-return trade-off thus involves an increased risk of illiquidity and the Profitability.

In order to discuss the risk-return trade-off, the following assumptions are made:

• That the current assets are less profitable than the fixed assets,
• Short term funds are cheaper than long term funds, and
• The firm has a fixed level of total funds inclusive of long term funds and short term funds; and a fixed level of total assets inclusive of current assets and fixed assets.

The effect of changing levels of current assets on the risk-return trade-off can be demonstrated as follows:

For a given firm, if the level of current assets is increased (it impliedly means that the fixed assets will reduce by the same amount) then the liquidity position of the firm will also increase and it will be easily meeting its payment commitments. But simultaneously its profit will decrease as the level of fixed assets has gone down. In other words, when the level of current assets is increased, the liquidity of the firm increases but there is always a cost associated with the increased liquidity. More and more funds will be blocked in current assets which are less profitable and therefore, the profitability of the firm will suffer.

Now, in order to increase the profitability, the firm reduces the current assets (and thereby increasing the fixed assets). Consequently, the profitability of the firm will increase but the liquidity will be reduced. The firm is now exposed to a greater risk of insolvency. The risk return syndrome can be summed up as follows : When liquidity increases, the risk of insolvency is reduced but the profitability is also reduced. However, when the liquidity is reduced, the profitability increases but the risk of insolvency also increases. So, the profitability and risk move in the same direction. What is required on the part of the financial manager is to maintain a balance between risk and profitability. Neither too much of risk nor too much of profitability is good.

5.3 Types of Working Capital Needs

Another important aspect of working capital management is to analyze the total working capital needs of the firm in order to find out the permanent and temporary working capital. It has already been discussed that the working capital is required because of existence of operating cycle. Moreover, the lengthier the operating cycle, greater would be the need for working capital. The operating cycle is a continuous process and therefore, the working capital is needed constantly and regularly. However, the magnitude and quantum of working capital required will not be same all the times, rather it will fluctuate.

The need for current assets tends to shift over time. Some of these changes reflect permanent changes in the firm as is the case when the inventory and receivables increase as the firm grows and the sales becomes higher and higher. Other changes are seasonal as is the case with increased inventory required for a particular festival season. Still others are random, reflecting the uncertainty associated with growth in sales due to firm specific or general economic factors. The working capital need therefore, can be bifurcated into permanent working capital and temporary working capital as follows:

5.3.1 Permanent Working Capital

There is always a minimum level of working capital which is continuously required by a firm in order to maintain its activities. Every firm must have a minimum of cash, stock and other current assets in order to meet its business requirements irrespective of the level of operations. Even during slack season, every firm maintains some current assets. This minimum level of current assets which must be maintained by any firm all the times, is known as permanent working capital for that firm. This amount of working capital is constantly and regularly required in the same way as fixed assets are required. So, it may also be called fixed working capital.

5.3.2 Temporary Working Capital

Over and above the permanent working capital, the firm may also require additional working capital in order to meet the requirements arising out of fluctuations in sales volume. This extra working capital needed to support the increased volume of sales is known as temporary or fluctuations working capital. For example, in case of spurt in sales, more stock must be maintained in order to meet the demand. This additional inventory may become excess when the normal sales level reappears after some time.

It may be noted that both the permanent working capital and temporary working capital are necessary for every firm and the financial manager must make a distinction between the two. The permanent working capital, once decided and arranged may not require regular attention or management as such. But care must be taken of the temporary working capital. The firm must be able to arrange additional working capital immediately whenever need arises. The temporary working capital is needed to meet the temporary liquidity requirements only. The distinction between permanent working capital and temporary working capital has been depicted in Figure 12.3.

Figure 12.3 shows that the permanent working capital may either be constant over a period of time or may be increasing over a period of time. Further, that the permanent working capital is constant or increasing regularly while the temporary working capital is fluctuating from time to time. The bifurcation of total working capital into permanent and temporary components is relevant for the working capital policy decisions relating to financing of working capital needs. As discussed later, a financial manager has to decide about the financing of permanent and temporary working capital from different sources. Moreover, he is to arrange funds for investment in temporary working capital needs without loss of time. He is in fact, required to manage the total working capital needs in such a way as to keep available sufficient working capital to the firm as and when required.

6. Financing of Current Assets

Another important aspect of working capital management is to decide the pattern of financing the current assets and one of the major problem in working capital management is the decision whether to finance the working capital with one source or the other. The firm has to decide about the sources of funds which can be availed to make investment in current assets. Breaking down working capital needs into permanent and temporary components over time provides a useful by-product in terms of financing choice. The permanent component is predictable insofar as it is linked up to expected change in sales or cost of goods sales over time. The temporary component is also predictable in general as it follows the same pattern every year. So, the two components of working capital need to be financed accordingly for which the different sources of funds can be grouped as follows:

• Long-Term Sources which provide funds for a relatively longer period. Under this category the main sources are the share capital, retained earnings, debentures and long term borrowing.
• Short-Term Sources which usually provide funds for a short period say up to one year or so. In this category, the main sources are bank credit, public deposit, commercial papers, factoring etc.
• Transactionary Sources which provide funds to a business through the normal business operations e.g., credit allowed by suppliers and outstanding labour and other expenses. To the extent the firm delays or postpones the payments, the funds are available to it and that too generally at no cost. These are also called spontaneous sources of finance.

For example, as the firm acquires its inventories, the trade credit is often made available spontaneously or on demand, by the supplier. The trade credit varies directly with the firm’s purchases of inventory items. In turn, the inventory purchases are related to the anticipated sales. Thus, a part of the financing needed by the firm is spontaneously provided in the form of trade credit. In addition, wages and salaries payable, accrued expenses, accrued interest and taxes also provide valuable sources of spontaneous financing.

It has been noted earlier that the net working capital is the excess of total current assets over total current liabilities. Thus, a part of total current assets is funded by current liabilities and only the remaining portion of current assets, known as net working capital, is to be arranged for. Therefore, the financial manager has to arrange funds for making investment in net working capital only. Different long term and short term sources of funds are available to a firm and all these sources are different from one another with respect to their nature and characteristics. The working capital requirements of a firm can be financed by all or any combination of these sources.

It may be noted that both the permanent and temporary components are predictable yet they differ on at least one dimension i.e., the permanent component of working capital is similar to an investment in fixed assets because it has to be replenished over time and thus requires financing for the long term. Consequently, it can be argued that this component should be financed with long term sources: either debt or equity or a combination of the two, depending upon the financing mix the firm chooses to use for financing long term assets. A part of permanent working capital may be financed by current liability also depending upon the trade-off between risk of having current liabilities and the cost associated with long term financing. The temporary component of working capital should be financed with pre-arranged lines of short term credit and the current liabilities. There are different approaches to take this decision relating to financing mix of the working capital as follows:

6.1 Hedging Approach (also known as Matching Approach)

The Hedging Approach to working capital financing is based upon the concept of bifurcation of total working capital needs into permanent working capital and temporary working capital. As the name itself suggests, the life duration of current assets and the maturity period of the sources of funds are matched. The general rule is that the length of the finance should match with the life duration of the assets. That is why the fixed assets are always financed by long term sources only. So, the permanent working capital needs are financed by long term sources. On the other hand, the temporary working capital needs are financed by short term sources only. In other words, the core or fixed working capital is financed by long term sources of funds while the additional or fluctuating working capital needs are financed by the short term sources. The hedging approach to working capital financing has been shown in Figure 12.4.

For example, a seasonal expansion in inventories should be financed with short term loan or liabilities. The rationale of the hedging principle is straight forward. Funds are needed for a limited period say for purchase of additional inventory, and when that period is over, the cash needed to repay the loan will be generated by the sale of extra inventory items. Obtaining the needed funds from a long term source would mean that the firm would still have the fund after the inventories had already been sold. In this case, the firm would have excess liquidity, which it either holds in cash or marketable securities until the seasonal increase in inventories occurs again. The result of all this would be to lower the profits of the firm.

The financing mix as suggested by the hedging approach is a desirable financing pattern. However, it may be noted that the exact matching of maturity period of current assets and sources of finance is always not possible because of uncertainty involved.

6.2 Conservative Approach

As the name itself suggests, under this approach the finance manager does not undertake risk. As a result, all the working capital needs are primarily financed by long term sources and the use of short term sources may be restricted to unexpected and emergency situation only. The working capital policy of a firm is called a conservative policy when all or most of the working capital needs are met by the long term sources and thus the firm avoids the risk of insolvency. The conservative approach to financing of working capital has been shown in Figure 12.5 and Figure 12.6.

So, under the conservative approach, the working capital is primarily financed by long term sources. The larger the portion of long term sources used for financing the working capital, the more conservative is said to be the working capital policy of the firm. In case, the firm has no temporary working marketable securities. This will help the firm to earn some income. Figure 12.6 shows that the firm uses a small amount of short term sources to meet its peak level working capital needs. It also stores liquidity in the form of marketable securities in slack season. The light shaded area in Figure 12.6 shows the use of short term financing for meeting the short term needs while the dark shaded shows the investment of excess funds in marketable securities.

6.3 Aggressive Approach

A working capital policy is called an aggressive policy if the firm decides to finance a part of the permanent working capital by short term sources. So, the short term financing under aggressive policy is more than the short term financing under the hedging approach. The aggressive policy seeks to minimize excess liquidity while meeting the short term requirements. The firm may accept even greater risk of insolvency in order to save cost of long term financing and thus in order to earn greater return. The aggressive approach to financing of working capital has been shown in Figure 12.7.

6.4 Hedging Approach (HA) versus Conservative Approach (CA)

The HA and CA are the two extreme approaches and do not help much the financial manager in managing the working capital needs. The HA is more risky as the short term (current) assets are financed by short term liabilities only and the firm may not have sufficient liquidity with it. On the other hand, the CA is more costly as the long term sources may remain idle in slack period. But, the CA is definitely less risky as more or less all the requirements of working capital needs are financed by long term sources.
The CA provides liquidity in excess of expected needs and thus minimizes the risk of (i) not being able to finance spontaneous assets growth, and (ii) defaulting on maturing/obligations. Excess liquidity in the firm results in holding assets that are earning nil or an insignificant return. Thus, CA is a low risk-low return approach to working capital management. The comparative position of HA and CA with respect to working capital financing mix has been presented.

Hedging Versus Conservative Approach

Thus, the hedging approach suggests a low cost-high risk situation while the conservative approach attempts at high cost-low risk situation. Neither the hedging approach nor the conservative approach can be used by any firm in the strict sense. Therefore, the financial manager should try to have a trade-off between the hedging and conservative approach. Though, the trade-off between risk and profitability depends largely on the financial manager’s attitude towards risk, yet while doing so he must take care of the following factors:

• Flexibility of the Mix: The financing mix of the working capital must be flexible enough. If the working capital needs are expected to be arising for a short period only then short-term sources should be used so that whenever the funds are released, they can be refunded. In such a situation, if the firm opts for long term sources, then the firm may not be able to refund even if it desires to refund and the pre-payment penalties may be prohibitory.
• Cost of Financing: The financial manager should also take into account the respective cost of financing from short term sources and long term sources. It is worth noting that it is not the rate of interest which is material, but the total cost of financing over a period of say one year, is relevant. For example, a firm has opportunity of raising funds by the issue of 14% debentures (7 years) or by taking a working capital term loan @ 18%. In this case, the rate of interest on long term source (i.e., 14% on 7 years debentures) is lower but it does not mean that the firm should go only for long term sources. The financial manager should also find out the annual cost of financing. In case of debenture issue, interest for full year would be payable while in case of short term bank loan, interest at the rate of 18% would be payable only for the period for which the bank loan facility is availed. It is quite likely that the total interest payable on bank loan in a year may be much lower than the annual cost of interest on debenture.
• Risk Attached with Financing Mix: It is already noted that the short term financing is more risky. If the firm opts for short term sources to finance the current assets, then it may have to renew the borrowing at the end of each maturity. Moreover, the total cost of financing may fluctuate from one period to another depending upon the short term interest rates. But in case of long term financing, there is no risk regarding the cost of financing and renewals.

6.5 Conservative Approach versus Aggressive Approach

Unlike the aggressive approach, the conservative approach requires the firm to pay interest on unneeded funds. The lower cost of the aggressive approach, therefore, makes it more profitable than the conservative approach, but the former is much more risky. The contrast between these two approaches should clearly indicate the trade-off between profitability and risk. The aggressive approach provides high points but also high risk, while the conservative approach provides low profits and low risk. A trade-off between these two extremes should result in an acceptable financing strategy for most of the firms.

6.6 Risk-Return Trade-off

The financing of current assets involves a trade off between risk and return. A firm can choose from short or long-term sources of finance. Short-term financing is less expensive than long-term financing but at the same time, short-term financing involves greater risk than long-term financing. Depending on the mix of short-term and long-term financing, the approach followed by a company may be referred as matching approach, conservative approach and aggressive approach. It matching approach, long-term finance is used to finance fixed assets and permanent current assets, and short-term financing is used to finance temporary or variable current assets. Under the conservative plan, the firm finances its permanent assets and also a part of temporary current assets with long-term financing and hence less risk of facing the problem of shortage of funds.

An aggressive policy is said to be followed by the firm when it uses more short-term financing than warranted by the matching plan and finances a part of its permanent current assets with short-term financing. The discussion regarding the financing pattern of current assets point out a conflict between the short term and long term sources of finance. This conflict between the two arises because of fact that these sources have (i) different cost of financing, and (ii) different risk associated with them. A financial manager should therefore, strive for a trade-off between the risk and return associated with the financing mix. Such risk-return trade-off has been shown in Figure 12.8.

Figure 12.8 shows that the hedging approach results in a low costs-high risk situation while the conservative approach results in a high cost-low risk situation. The trade a off between risk and return give a financing mix that lies between these two extremes. For this purposes, the risk and return associated with different financing mix can be analyzed and accordingly a decision can be taken up. One way of achieving a trade-off is to find out, in the first instance, the average working capital required (on the basis of minimum and maximum during a period). Then this average working capital may be financed by long term sources and other requirements if any, arising from time to time may be met from short term sources. For example, a firm may require a minimum and maximum working capital of ` 10,000 and ` 18,000 respectively during a particular year. The firm have long term sources of ` 14,000 (i.e., average of ` 10,000 and ` 18,000) and additional requirements over and above ` 14,000 may be met out of short term sources as and when the need arises.

6.7 Optimal Working Capital Policy

Given the trade-off between the effects of increasing working capital and the effects of reducing liquidity risk, it can be argued that working capital should be increased if and only if the benefits exceeds the costs. To put it differently, there is correlation between the firm value and the level of working capital investment. At least initially, increase in working capital may lead to increase in firms value, because the marginal benefits are likely to exceed the costs. At some level of working capital, holding all other factors constant, the firm’s value should be maximized. This is the optimum level of working capital for the firm. In general, the working capital as a measure of liquidity risk suggests that increasing working capital will generally, reduce the liquidity risk faced by the firm, whereas decreasing the working capital will generally increase the liquidity risk. The effects of working capital changes on the liquidity risk depend on a number of factor such as:

• Stand-by sources: A firm with stand-by sources of external financing is less exposed to liquidity risk than the firm which does not have such access, because the former can tap these sources if it needs to cover the increasing current liabilities.
• Economic Conditions: Holding other factors constant, firms typically experience larger changes in liquidity risk as a consequence of working capital change when the economy is in recession than when it is in boom.
• Future Uncertainty: To the extent that future operations of the firm are predictable and stable, the firm can survive with lower investment in working capital than could, otherwise similar firms which have more uncertainty about the future operations.

Therefore, the working capital policy adopted by a firm should be framed after due consideration of a host of factors. It would be better if the working capital policy is viewed and framed in terms of separate assets and liabilities policies. A conservative firm will tend to have conservative policies for both the current assets and the current liabilities, while an aggressive firm will tend to have aggressive policy for both the current assets and the current liabilities. In fact, a firm should strive for an overall optimal working capital policy for which the following points are worth noting:

• Individual current assets and current liabilities policies should be framed so as to reduce or avoid larger degree of risk in any such policy,
• One aggressive policy may be off-set by an other conservative policy. For example, a firm may have a conservative policy for current assets but aggressive policy for current liabilities. The overall result will tend to be moderate working capital policy for the firm. Such a moderate policy will be optimal working capital policy for the firm. This will help in maximizing the value of the firm for the level of risk assumed by the firm.

7. Working Capital Monitoring and Control

It goes without saying that the working capital quantum as well as its financing pattern are subject to constant monitoring and review by the financial manager, care must be taken that the working capital structure remains as intended to be. There are different analytical tools which can help a financial manager in monitoring, reviewing and controlling the working capital, some of which are as follows:

7.1 Monitoring the Operating Cycle

It is already noted that the total working capital need depends upon the length of the operating cycle. The lengthier the operating cycle, the greater would be the working capital need. The operating cycle of a firm is consisting of different cycles for different elements of working capital. Therefore, the financial manager must monitor the duration of all these individual operating cycles for different elements in order to effectively control the working capital. The following points are worth noting here:

• The actual operating cycle period should be ascertained for each element i.e., the raw materials, the work-in-progress, the finished goods, the receivables etc. over a period of time and should be compared with the standard operating cycle period set for the same firm or for the industry as a whole. Efforts should also be made to point out the reasons for differences in the actual operating cycle period and the standard operating cycle period.
• There should always be an attempt to reduce the length of the operating cycle, total as well as for each element. The standard operating cycle period need not be lowered but the actual operating cycle period must be kept as low as possible. This makes the firm have comfortable liquidity.
• Efforts in particular, are needed to control the Receivables Conversion Period. If the firm relaxes in collection, the customer will always like to take liberty.

7.2 Working Capital Ratios

Another analytical tool that can be used to monitor the working capital is the accounting ratios, particularly the working capital ratios. For this purpose, the following working capital ratios may be noted.

• Current ratio i.e., Current assets to Current liabilities Ratio,
• Liquid ratio i.e., Quick assets to Current liabilities Ratio,
• Current assets to Total assets ratio,
• Current assets to Total sales ratio.

These ratios may be ascertained for a number of years to find out the emerging working capital position of the firm. It may be noted that the Current Ratio is the most important one and it indicates the position of net working capital also. If the Current Ratio is more than 1, then the net working capital is positive. If the Current Ratio is 1, then the current assets are just equal to current liability and there is no net working capital. Further, if the Current Ratio is less than 1, then the current assets are less than the current liabilities and the firm has negative net working capital.

The Current Ratio as well as the Quick Ratio, both indicate the liquidity position of the firm vis-a-vis the current liabilities. However, the Quick Ratio is supposed to give a better indication of the liquidity since it excludes the stock which may not be immediately realizable. The standard form of Current Ratio and Quick Ratio is taken as 2:1 and 1:1 respectively.

7.3 Monitoring the Liquidity

Although, profitability and selection of goods investment are the keys to the prosperity of the firm in the long run, yet it is the liquidity which ensures the short term survival of the firm. Sufficient liquidity can be obtained by efficient management of different elements of working capital. If a firm faces liquidity problems, then it must be realized that this liquidity problem arises from lack of finance. The liquidity problem can be overcome in two ways

1. To raise additional funds from different sources. But this may not always be possible for the firm, and
2. The following steps may be taken by the firm to ease the liquidity problem :

(a) Reduce the safety stock, resulting in reduction of order size. This reduction in order size however, will have many repercussions such as more frequent and costly orders, loss of quantity discount, probability of stock-out etc., and therefore, must be decided very carefully.

(b) Another way of improving the liquidity may be to delay the payments to the creditors but this is not possible without impairing the goodwill of the firm.

(c) Liquidity can also be improved by concentrating more on collections of receivables. More effective control system should be introduced and the customers may be offered incentive for prompt payments. An improvement in collections definitely improves liquidity but it has a cost in terms of a possibility of a loss of customer. This aspect has been discussed in detail in Chapter 14.

8. Points to Remember

• The term working capital may be used to denote either the gross working capital which refers to total current assets or net working capital which refers to excess of current assets over current liabilities.
• The working capital requirement for a firm depends upon several factors such as operating cycle, nature of business, business cycle fluctuations, seasonally of operations, market competitiveness, credit policy, supply conditions etc.
• The operating cycle of a firm may be defined as the period from the procurement of raw materials goods to the realization of sales proceeds. It is consisting of the Inventory Conversion Period (ICT) and the Receivables Conversion Period (RCP). If the firm is receiving credit from the supplier of raw material/goods, then the Deferral Period (DP) may be deducted to find out the Net Operating Cycle (NOC).

NOC = ICP + RCP – DP

• Working capital management requires a trade off between liquidity and profitability. It may also be described as Risk-Return trade off.
• The working capital need of the firm may be bifurcated into Permanent and Temporary working capital.
• The Hedging Approach says that permanent requirement should be financed by long term sources while the temporary requirement should be financed by short term sources of finance.
• The Conservative Approach, on the other hand, says that the working capital requirement be financed primerly from the long term sources.
• The Aggressive Approach says that even a part of permanent requirement may be financed out of short term funds.
• Every firm must monitor the working capital position and for this purpose certain accounting ratios may be calculated.