Understanding of Working Capital


By

N. Kavitha
MBA, M.Phil, (Ph.D)
Lecturer-MBA,
SSM College of Engineering
Komarapalyam-638 183
 


Working capital :

Working capital may be regarded as the life blood of business. Working capital is of major importance to internal and external analysis because of its close relationship with the current day-to-day operations of a business. Every business needs funds for two purposes.

* Long term  funds are required  to create production facilities through purchase of fixed assets such as plants, machineries, lands, buildings & etc

* Short term funds are required for the purchase of raw materials, payment of wages, and other day-to-day expenses. . It is other wise known as revolving or circulating capital

It is nothing but the difference between current assets and current liabilities. i.e. Working Capital = Current Asset Current Liability.

Businesses use capital for construction, renovation, furniture, software, equipment, or machinery. It is also commonly used to purchase inventory, or to make payroll. Capital is also used often by businesses to put a down payment down on a piece of commercial real estate. Working capital is essential for any business to succeed. It is becoming increasingly important to have access to more working capital when we need it.

Importance of Adequate Working Capital

A business firm must maintain an adequate level of working capital in order to run its business smoothly. It is worthy to note that both excessive and inadequate working capital positions are harmful. Working capital is just like the heart of business. If it becomes weak, the business can hardly prosper and survive. No business can run successfully without an adequate amount of working capital.

Danger of inadequate working capital

When working capital is inadequate, a firm faces the following problems.

Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. Low liquidity position may lead to liquidation of firm. When a firm is unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the firm may be damaged because of lack of liquidity. Thus it will lose its reputation. There by, a firm may not be able to get credit facilities. It may not be able to take advantages of cash discount.

Concept of working capital

1) Gross Working Capital = Total of Current Asset
2) Net Working Capital = Excess of Current Asset over Current Liability

Current Assets

Current Liabilities

Cash in hand / at bank
Bills Receivable
Sundry Debtors
Short term loans
Investors/ stock
Temporary investment
Prepaid expenses
Accrued incomes

Bills Payable
Sundry Creditors
Outstanding expenses
Accrued expenses
Bank Over draft


One of the most important areas of finance to monitor is your company's working capital, which is the difference between current assets and current liabilities. As a small business owner, you must constantly be alert to changes in working capital and their implications; otherwise, you may miss some warning signs that can lead to business failure. The most important component of working capital is cash, far the most important asset of any business, particularly a small business. Without it, the business will fail. So it is of paramount importance for you as the business owner to control all cash transactions.

It is helpful for us, as a business owner, to think of working capital in terms of five components:

1. Cash and equivalents
. This most liquid form of working capital requires constant supervision. A good cash budgeting and forecasting system provides answers to key questions such as: Is the cash level adequate to meet current expenses as they come due? What is the timing relationship between cash inflow and outflow? When will peak cash needs occur? When and how much bank borrowing will be needed to meet any cash shortfalls? When will repayment be expected and will the cash flow cover it?

2. Accounts receivable. Many businesses extend credit to their customers. If you do, is the amount of accounts receivable reasonable relative to sales? How rapidly are receivables being collected? Which customers are slow to pay and what should be done about them?

3. Inventory. Inventory is often as much as 50 percent of a firm's current assets, so naturally it requires continual scrutiny. Is the inventory level reasonable compared with sales and the nature of your business? What's the rate of inventory turnover compared with other companies in your type of business?

4. Accounts payable. Financing by suppliers is common in small business; it is one of the major sources of funds for entrepreneurs. Is the amount of money owed suppliers reasonable relative to what you purchase? What is your firm's payment policy doing to enhance or detract from your credit rating?

5. Accrued expenses and taxes payable. These are obligations of your company at any given time and represent a future outflow of cash.

Working Capital policy


Principles of Risk variation

* Here risk refers to the inability of a firm to meet its obligation, when they become due for payment.
* There is a definite inverse relationship between the degree of risk & profitability.
* A management prefers to minimize risk by maintaining a higher level of current assets or working capital.

Principles of cost of capital

* Generally, higher the risk lower is the cost & lowers the risk, higher is the cost.
* A sound working capital management should always try to achieve a proper balance b/w these two.

Principles of equity position

* It is concerned with planning the total investment in Current Asset.
* Every rupee invested in the current assets should contribute to the net worth of the firm.

The level of Current Asset may be measured with the help of two ratios

  • Current assets as a % of total assets.
  • Current assets as a % of total sales.

Principle of maturity of payment

  • It is concerned with planning the sources of finance for working capital.
  • A firm should make every effort to relate maturities of payment to its flow of internally generated funds.

Estimation / forecast of working capital requirements

"Working capital is the life blood & controlling nerve centre of a business."  No business can be successfully run without an adequate amount of working capital.

  • To avoid the shortage of working capital at once, an estimate of working capital requirement should be made in advance.
  • But estimation of working capital requirements is not an easy task & a large no. of factors has to be considered before starting this.

Factors requiring consideration while estimating working capital.

  • The average credit period expected to be allowed by suppliers.
  • Total costs incurred on material, wages.
  • The length of time for which raw material are to remain in stores before they are issued for production.
  • The length of the production cycle (or) work in process.
  • The length of sales cycle during which finished goods are to be kept waiting for sales.
  • The average period of credit allowed to customers
  • The amount of cash required to make advance payment

Factors determining working capital requirements

  • Nature of business
  • Size of business
  • Production policy
  • Manufacturing process
  • Seasonal variations
  • Working capital cycle
  • Rate of stock turn over
  • Credit policy
  • Business cycles
  • Rate of growth of business
  • Price level changes
  • Earning capacity & dividend policy
  • Other factors.

Importance of Working Capital Ratios

Ratio analysis can be used by financial executives to check upon the efficiency with which working capital is being used in the enterprise. The following are the important ratios to measure the efficiency of working capital. The following, easily calculated, ratios are important measures of working capital utilization.

Ratio

Formulae

Result

Interpretation

Stock Turnover
(in days)

Average Stock * 365/
Cost of Goods Sold

= x days

On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management.
Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.

Receivables Ratio
(in days)

Debtors * 365/
Sales

= x days

It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ?
One or more large or slow debts can drag out the average days. Effective debtor management will minimize the days.

Payables Ratio
(in days)

Creditors * 365/
Cost of Sales (or Purchases)

= x days

On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.

Current Ratio

Total Current Assets/
Total Current Liabilities

= x times

Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.

Quick Ratio

(Total Current Assets - Inventory)/
Total Current Liabilities

= x times

Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.

Working Capital Ratio

(Inventory + Receivables - Payables)/
Sales

As % Sales

A high percentage means that working capital needs are high relative to your sales.


Other working capital measures include the following:

Bad debts expressed as a percentage of sales.
Cost of bank loans, lines of credit, invoice discounting etc.
Debtor concentration - degree of dependency on a limited number of customers.

Once ratios have been established for our business, it is important to track them over time and to compare them with ratios for other comparable businesses or industry sectors.

A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as:

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 (cash, accounts receivable, inventory).
Also known as "net working capital".

If a company's current assets do not exceed its current liabilities, then it may 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.

Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow 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.

Working Capital Cycle

Cash flows in a cycle into, around and out of a business. It is the business's life blood and every manager's primary task is to help keep it flowing and to use the cashflow to generate profits. If a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out of cash and expire. The faster a business expands, the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash will help improve profits and reduce risks. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm's total profits.

There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-progress) and Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.


Each component of working capital (namely inventory, receivables and payables) has two dimensions ........TIME ......... and  MONEY. When it comes to managing working capital - TIME IS MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales.

Sources of Additional Working Capital

Sources of additional working capital include the following:

    * Existing cash reserves
    * Profits (when you secure it as cash !)
    * Payables (credit from suppliers)
    * New equity or loans from shareholders
    * Bank overdrafts or lines of credit
    * Long-term loans

If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading. Early warning signs include:

    * Pressure on existing cash
    * Exceptional cash generating activities e.g. offering high discounts for early cash payment
    * Bank overdraft exceeds authorized limit
    * Seeking greater overdrafts or lines of credit
    * Part-paying suppliers or other creditors
    * Paying bills in cash to secure additional supplies
    * Management pre-occupation with surviving rather than managing
    * Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).

CONCLUSION

Any change in the working capital will have an effect on a business's cash flows. A positive change in working capital indicates that the business has paid out cash, for example in purchasing or converting inventory, paying creditors etc. Hence, an increase in working capital will have a negative effect on the business's cash holding. However, a negative change in working capital indicates lower funds to pay off short term liabilities (current liabilities), which may have bad repercussions to the future of the company. If you would like to get a better understanding of financial statements or budgeting contact nkavithamba@yahoo.co.in.
 


N. Kavitha
MBA, M.Phil, (Ph.D)
Lecturer-MBA,
SSM College of Engineering
Komarapalyam-638 183
 

Source: E-mail April 3, 2007

       

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