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Working Capital Management Essentials

Working capital refers to the capital required to finance short-term assets like inventory, accounts receivable, and cash, and is calculated as current assets minus current liabilities. Proper management of working capital elements like inventory, receivables, payables, and cash is important for business liquidity and avoiding issues like inability to pay bills, overstocking, and overtrading. The length of a company's operating cycle, which is the time between paying for raw materials and collecting cash from sales, depends on factors like liquidity versus profitability decisions, terms of trade, management efficiency, and industry norms.

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63 views20 pages

Working Capital Management Essentials

Working capital refers to the capital required to finance short-term assets like inventory, accounts receivable, and cash, and is calculated as current assets minus current liabilities. Proper management of working capital elements like inventory, receivables, payables, and cash is important for business liquidity and avoiding issues like inability to pay bills, overstocking, and overtrading. The length of a company's operating cycle, which is the time between paying for raw materials and collecting cash from sales, depends on factors like liquidity versus profitability decisions, terms of trade, management efficiency, and industry norms.

Uploaded by

Sangeetha K S
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© © All Rights Reserved
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Estimation of working

Capital
BY DR. SHARON K JOSE
 Working Capital =Current Asset –Current Liabilities
Working Capital

 Working Capital refers to that part of the firm’s capital, which is required
for financing short-term or current assets such a cash marketable securities,
debtors and inventories. Funds thus, invested in current assets keep revolving
fast and are constantly converted into cash and this cash flow out again in
exchange for other current assets.
 Working Capital is also known as revolving or circulating capital or short-
term capital.
Importance of working capital
management
 Current assets are a major financial position statement item and especially
significant to smaller firms. Mismanagement of working capital is therefore a
common cause of business failure, e.g.:
 inability to meet bills as they fall due
 demands on cash during periods of growth being too great (overtrading)
 overstocking
The balancing act: Profitability v
Liquidity
The main sources of liquidity are usually:

 Cash in the bank


 short-term investments that can be cashed in easily and quickly
 cash inflows from normal trading operations (cash sales and
payments by receivables for credit sales)
 an overdraft facility or other ready source of extra borrowing.
 Cash balances and cash flows need to be monitored just as closely
as trading profits.
Elements of working capital

 Managing working capital involves managing the individual elements which


make up working capital:
 inventory (stock)receivables
 (debtors)payables
  (creditors)cash
Permanent or fluctuating current assets

 In most businesses a proportion of the current assets are fixed over time, i.e.
'permanent'.
 The choice of how to finance the permanent current assets is a matter for
managerial judgement, but includes an analysis of the cost and risks of short-term
finance.
The attitude of management to risk: aggressive,
conservative and matching funding policies

 Aggressive - finance most current assets, including 'permanent' ones, with short-term finance. Risky but
profitable.
 Conservative - long-term finance is used for most current assets, including a proportion of fluctuating current
assets. Stable but expensive.
 Matching - the duration of the finance is matched to the duration of the investment.

 A firm choosing to have a lower level of working capital than rivals is said to have an 'aggressive' approach,
whereas a firm with a higher level of working capital has a 'conservative' approach.
Over-capitalisation

 If there are excessive inventories, accounts receivable and cash,and very few
accounts payable, there will be an over-investment by the company in current
assets. Working capital will be excessive and the company will be over-
capitalised.
Overtrading

 In contrast to over-capitalisation, if the business does not have access to

sufficient capital to fund the increase, it is said to be“ overtrading". This can

cause serious trouble for the business as it is unable to pay its business

creditors.
The elements of the operating cycle
Factors affecting the length of the
operating cycle
Length of the cycle depends on:
 liquidity versus profitability decisions
 terms of trade
 management efficiency
 industry norms, e.g. retail versus construction.
Practice Problem
Ratios to determine the operating cycle

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