Working Capital Management - Determinants

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          Working Capital refers to that part of capital which is necessary to cover the cost of operating enterprises i.e., to meet the day to day requirements of the business concern. It is also referred as circulating capital as the current assets of the business are changed in the ordinary course of business from one form to other. It also represents the excess of current assets over current liabilities including short-term loans. 

• Gross Working Capital - GWC: Capital invested in total current assets of the business
• Net Working Capital - NWC: The excess of current assets over the current liability of the concern during a particular period

GWC = CA; NWC = CA - CL

Working capital is needed for purchase of raw materials, payment of wages and salary, day-to-day expenses and to provide credit obligations. A business concern must maintain a sound working capital for efficient management of business operations. Excessive working capital can lead to unnecessary accumulation of inventories, indicates a defective credit policy and slack in collection period leading to reduction in profits. Inadequate working capital stagnate growth and becomes difficult to implement the operating plans thus reducing the overall operation of the business and profits. Both excessive and inadequate working capital positions are dangerous for the growth of the firms.

Types of Working Capital:

« Permanent or fixed working capital: The minimum level of required current assets by a firm to carry on its business operations.

« Fluctuating or variable working capital: The additional working capital needed to support the changing production and sales activities of the firm. It can be further classified into:

« Seasonal Working Capital: To meet the seasonal needs of the business

« Special Working Capital: To meet the special purposes such as extensive marketing campaigns for conducting research

Determinants of Working Capital:

The following are the factors which determine the working capital requirements of firms:

« Nature of business

« Market and demand conditions

« Technology and Manufacturing policy

« Credit Policy

« Availability of credit from suppliers

« Operating Efficiency

« Growth and Expansion of firm

Estimation of Working Capital Needs:

• Based on current assets holding period: When and How much current assets as inventories required and how much cash required to meet the short term obligations
• Based on Ratio of sales: To estimate the working capital requirements as a ratio of sales on the assumption that current assets change with sales
• Based on Ratio of fixed investments
• Based on operating cycle of the business: The most appropriate method for computation of working capital 

Working Capital Management Policy:

Working Capital Management refers to the administration of working capital – determination of levels and composition of current assets. There is a great relationship between a firm’s growth and its working capital needs. To decide the levels and financing of current assets, the risk-return implications must be evaluated. The level of current assets can be measured by relating current assets to fixed assets (CA/FA) ratio. Assuming a constant level of fixed assets,

« Higher CA/FA ratio – Conservative policy – Greater liquidity and Lower risk –suitable to meet the seasonal fluctuation of the manufacturing operation

« Lower CA/FA ratio – Aggressive policy – Poor liquidity and Higher risk – suitable at high level of sales

« Moderate policy – falls in the middle of the above two policies – suitable for maintaining moderate level of sales

Cost of Liquidity: It is the cost of holding excessive current assets. If the firm’s current assets level is high, it has excessive liquidity thus returns will be low as the funds are tied up as idle cash, stocks are piled up and high level of debtors in turn reduce profitability.

Cost of Illiquidity: It is the cost of holding insufficient current assets. IF the firm’s currents assets level is low, it has too little cash and low level of stocks to honor its obligations thus losing the credit worthiness and sale of inventories.

To determine the optimum level of current assets the firm should minimize both the costs of liquidity and illiquidity. In shaping its working capital policy, the firm should consider relative asset liquidity and relative financing liquidity.

Financing of Current assets:

• Long term financing: Ordinary share capital, preference share capital, debentures, long-term borrowings from financial institutions and reserves and surplus
• Short term financing: Advance from suppliers, working capital funds from banks, public deposits, commercial paper, factoring of receivables
•  Spontaneous financing: Automatic sources of short-term funds arising in the normal course of business – Trade credit, outstanding expenses

Short term financing may be preferred over long term financing for two reasons: cost advantage and flexibility. But it is riskier than long term financing.

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

« Hedging or Matching Approach: When the firm follows a matching 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. Under this plan, no short term financing will be used if the firm has a current assets need only.

« Conservative Approach: Under conservative plan, the firm finances its permanent asset and also a part of temporary current assets with long-term financing. When the firm has no need for temporary current assets, the long-term funds can be invested in marketable securities to buildup the liquidity position of the firm

« Aggressive Approach: Under an aggressive policy, the firm finances a part of its permanent current assets and some firms even a part of their fixed assets with short term financing. The relatively large use of short-term financing makes the firm more risky.