A Seminar Paper On Working Capital Management Finance Essay
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Published: Mon, 5 Dec 2016
MBA (Tech.) focuses on making student’s concepts clearer and stronger by including seminar paper presentations its curriculum. I want to pursue my career in the field of finance. That is why I opted to present a seminar paper on “MANAGING CASH FOR YOUR BUSINESS”, a seminar paper on Working Capital Management.
The seminar paper covers all the components and aspects of Working Capital Management (WCM) and how an efficient and effective WCM can help businesses maintain smooth cash flows and profitability thereby maintain large market shares.
Every business right from a paint manufacturer to a retailer face many challenges for sustenance. Global competition has increased manifold and as a result there is cut-throat battle between businesses to reduce costs at which goods and services are sold to consumers. Cutting down on profit margins, increases the need to make operational activities more efficient.
Cash is the lifeline of each and every business organization. Thus, it is very important to manage proper cash inflows and outflows. Working Capital Management (WCM) deals with management of the cash flows within an organization. WCM not only deals with management of money earned and spent by the company but also deals with proper handling of company’s balance sheet.
The company’s financial structure is improved so that cash resources are not tied up. Efficient WCM not only optimizes the cash flow cycles but also increases the efficiency of the entire company. It releases the resources with high liquidity by reducing inventory levels and making more cash readily available at hand.
Every company needs cash for its existence. Cash is imperative for sustenance of each and every firm. If the cash inflows and outflows of a firm are not proper, then the firm cannot function properly. It cannot manage its day-to-day operational activities, it cannot invest/reinvest nor can it pay for its invoices from suppliers and other capital requirements for providing services and goods to consumers.
Thus, understanding the cash flow play a very important role in decision making. The cash flow of a company reflects its health and market position. A company with good cash flows is said to be in good health.
Understanding the cash flows is done by using working capital management. This helps companies managing their cash outflows and inflows efficiently and also helps keep them in good books of investors and suppliers.
THE CONCEPT OF WORKING CAPITAL
The cash which is required by companies for their daily operational activities is known as working capital. The working capital is used to supplement the conversion of raw materials into finished goods, selling of which generates profits for a company.
Working capital in business firms is analogous to blood in human body. When it is accurately handled, the firms flourish and expand but its inefficient management can cause infirmity to all operations within the firm. Thus, managing of working capital plays a very important part in today’s organizations and its proper management can help a company to put itself on track on rapid success.
Let us consider a pizza sauce manufacturing company. The company uses Rs. 5000 to purchase the raw materials required to manufacture pizza sauce. The ingredients like onions, tomatoes, chilly, pepper etc are purchased and stocked as inventory for manufacturing of the sauce. The company takes a week to manufacture one order of pizza sauce bottles. It dispatches the order and receives the payment after one week. Thus, the Rs.5000 investment in pizza sauce making is the WORKING CAPITAL of the company. This Rs.5000 is held up for 2 weeks. If the company can sell these bottles more quickly, then the payment will come sooner and it can again buy new ingredients for the second round of orders.
If company fails to get any orders then it inventory stocks of ingredients will remain on stockpiles and the cash used in their purchase will remain tied up. Sometimes, the invoice payments are also delayed, which again ties up the cash being put in the business. In such a situation, the company will have to borrow from outside to purchase new stock of inventory for its next orders till the payment of previous orders is struck up.
Hence, for the given example, the company will have to borrow as much less as much well it manages its working capital.
Not just this company, but every company needs to properly manage its working capital so that its cash can be invested in profit maximizing ways.
WORKING CAPITAL CYCLE
As shown in the cycle above, industries/firms convert their cash into prepaid expenses and inventories. This inventory is used to produce goods and services for consumers. When goods and services are delivered, an invoice of the same is generated by the firm which is to be paid by the consumer. At this stage, it is said that goods and services get converted to accounts receivables as their sale would get cash into the firm. Once the consumer pays off the invoices for purchased goods and services, account receivables get converted into cash. Again this cash is used by firms to expand their business and the cycle moves on.
WORKING CAPITAL CLASSIFICATION
Working capital is generally classified under two head:
Gross working capital: The firm’s investment in current assets which are easily convertible to cash (within a period of 1 accounting year). These current assets are cash, receivables, debtors and short-term securities.
Net working capital: Net working capital is commonly known as working capital and it is given by the following equation:
WORKING CAPITAL=CURRENT ASSETS – CURRENT LIABILITIES
Current liabilities mentioned above have maturity period of 1 accounting year and include payables, creditors and outstanding expenses.
Permanent working capital: It is the minimum amount of working capital that a firm requires for management of its day-to-day operational activities. It is the fixed amount and this much is always required by the company.
Temporary working capital: It is the extra working capital (over and above permanent working capital) that is required by a company when any of the follwing parameters undergo a change:
Sales Volume variations
Fluctuations in price levels
Companies for which the difference of current assets minus current liabilities is positive are the ones with high liquidity rates and can convert their assets to cash as and when needed. When company does not possess enough assets to cover up its liabilities, it can have problems in paying back for the short-term loans to the creditors. Very low asset level may even lead to bankruptcy.
WORKING CAPITAL MANAGEMENT
Working capital management is the managing of current assets (that is, working capital) by business firms. A company might posses’ assets and is profitable but if it cannot convert its current assets into cash readily then it is said to have less liquidity.
Management of working capital require firms to strike a balance between the amount of short-term assets and liabilities that they should maintain to ensure efficient management of its all firm’s operations. It also helps the firm in repaying back for short term borrowings and any other impending expenses.
Working capital management is one of the best methods which is being used to check the health of a company and determine how well it is doing. A company’s position is determined by its profitability which is a function of working capital (more the working capital better is the financial condition of the company). The investors and other competitors check a company’s balance sheet to see the calculation of its working capital and determine it financial well being.
Thus, by knowing the working capital amount of a firm, one can judge firm’s performance and contemplate its growth and advancement. A firm can prosper only by having the adequate amount of working capital.
Working capital management deals with efficient and effective management of the level of currents assets and current liabilities that a company must hold and how current assets can be used to cover up for current liabilities.
WORKING CAPITAL MANAGEMENT GOALS
The three major goals of working capital management are:
But the major goal is to achieve all the above stated goals and never be out of cash, that is, the companies must have working capital (cash) readily available. This is ensured by investing some cash in marketable securities which can be easily liquefiable and by limiting short-term borrowing of the firm.
These goals are very industry specific and change in accordance to the type of industry working capital management is applied too. For some industries even zero liquidity can be advantageous and can yield high profitability. Such industries do not maintain net working capital rather use the credit amounts for day-to-day maintaining operational activities.
WORKING CAPITAL MANAGEMENT PROCESSES
Working capital management involves two processes:
WORKING CAPITAL MANAGEMENT
Determining the size of working capital
Arranging the sources of working capital
1. Determining the size of working capital: For every industry, there are different parameters based on which one can decide the adequate amount of working capital. Some of the factors contributing to this decision making process is as follow:
Nature of the industry
Volumes of sales
Supply of raw materials
Size of Business
Terms of purchase and sales
Growth and expansion
Price level variations
2. Arranging the sources of working capital: The sources of working capital are arranged depending of the fund’ availability and the kind of use working capital is put to. Working capital basically involves the following components:
Cash and cash balance
Thus, management of working capital deals with managing of these four components in a company. These components are managed in the following manner:
As shown in the above table, companies try to achieve low levels of accounts receivables and inventories and high levels of account payables. Following such kind of a practice increases the cash flow and profitability of the company.
LITERATURE REVIEW ON EXISTING WCM
Substantial work has already been on the concept of working capital and its management. The key driver that gives momentum to profitability of a company is efficient and effective working capital management. Scientists and other financial experts claim that when various components of WCM are managed in an organised manner than the worthiness of such practices increases and contribute towards the upliftment of the entire organization.
Although there is a lot of data available on the subject, still more research is required in this area. Concepts of WCM are applicable to various industries like finance, manufacturing, chemical etc. WCM is applied in a variety of areas based on consultancy by SMEs (Subject Matter Experts).
In this study, I have tried to study the impact and consequences of efficient working capital management and how various industries apply it within their specific context.
POLICIES FOR WORKING CAPITAL MANAGEMENT
As seen in the above diagram, working capital management is governed by three policies:
ANALYSIS OF WORKING CAPITAL
No matter what kind of business one is into, working capital will surely impact the cash flow of the business. It is the key driver of cash flow in any firm. Thus, a very good understanding and analysis of working capital becomes crucial for firms to be successful.
Working capital is analyzed using one of the following methods:
All these methods are adopted to study the pattern of changing position of working capital for a particular firm and to predict future needs of working capital so that it is readily available for use as and when required.
Besides these methods an easier way to analyze working capital is to calculate the OPERATING CYCLE.
This cycle analyzes the following parameters in terms of days:
The average no. of days which are taken to collect accounts analyzes the accounts receivables. Average no. of days taken to convert a product from the time it enters the firm to the time it is converted to cash/account receivables, analyzes the inventory. And the average no. of days taken to pay back the supplier analyzes the account payables.
Generally it is very difficult for firms to finance their operating cycles only with the financing of accounts payable. Thus, the need for financing of working capital arises. The operating cycle is financed by both accounts payable financing and working capital financing.
Now, using working capital to finance the operating cycle generates a need cover up for the loss of working capital by some other means. This shortage of working capital is done away with by using borrowed funds (internal/external/combination of both) to generate net profits.
Majority of the businesses need working capital for short -term financing of their operational activities. For example, a retailer selling crackers faces a seasonal rise in customer demand during Diwali period and hence needs working capital to finance the extra inventory stocks during the peak season. Working capital funds seasonal hikes in inventory and resulting build-ups in account receivables during such seasonal peaks.
Few common sources of short-term financing by working capital are:
1. Equity: Equity refers to funds that are taken from some personal asset or from a friend/family member or from some investor. These equity funds are generally utilised during initial years of establishment of a new firm for its short-term financing.
2. Trade creditors: Maintaining good relations with suppliers proves very fruitful in getting trade credits from them. Companies which have always lived up to the terms and conditions of the suppliers and have made timely payments of their invoices, can extend the credit period of their payments. Once the credit period is extended, the money can be used as a source of short-term financing.
3. Factoring: Many new business adopt factoring approach for short-term financing wherein, after placing an order, the company factors its account receivables to some other company which henceforth manages all its collections and pays the factoring company some amount as the interest of the same which is used for financing.
4. Line of credit: Bank borrowings from banks are known as Line of credit. These borrowing are generally for a small period of time, say around a year or so.
5. Short-term loan: In many situations, company do not qualify to get a line of credit sanctioned from banks. In such cases they might apply for short-term loans at pretty decent interest rates for short-term financing.
TYPICAL PROBLEMS FACED DURING WORKING CAPITAL OPTIMIZATION
Every company is trying to strike a balance between its current assets and current liabilities so that current assets overrun the current liabilities and the company has sufficient working capital to manage its operations. But optimizing of working capital is not simple and faces the following challenges:
Every company is facing a stiff competition on the global scale due to which it has huge pressures on profit margins. Everyone is trying to win the race by reducing prices of goods and services being offered to the consumers.
Due to such intensive cost cutting, companies are forced to keep high inventories which has made their cash flows unstable and deteriorated its performance.
Companies are trying to expand more. They are entering into costly acquisitions which are in turn creating shortage of funds at hand and increased debt burdens on the company thereby decreasing overall company profits.
Hence, when companies try and overcome these challenges then only they can have adequate amount of working capital at hand leading to following effects:
More capital is available for investments
Business processes get optimized yielding maximum output due to focus on identified drivers of working capital
Liquidity of the firm is protected
Profitability of the firm increases manifold
VARIATIONS IN WORKING CAPITAL ACROSS INDUSTRIES
Working capital has different relevance with reference to different kind of companies. Some common variations seen are as follow:
1. Businesses like Supermarkets have very few debtors as these companies possess large cash balances and minimal creditors.
2. Some businesses deal with sale and purchase of only finished products. Such kinds of dealers do not need to maintain any raw material/work in progress stocks. Hence such companies automatically have more cash in hand as inventory management is narrowed down to managing only finished goods and thus have a larger share of working capital.
3. Insurance companies are financially stronger as compared to other companies because they receive premium payments from customers before they make any payment. In spite of this, insurance companies have highly unpredictable cash outflows. When insurance claims come up, they have to make huge payments sometimes even without any prior notice.
4. When it comes to retailers, their major focus is on inventories as accounts receivables are of no problem because customer pays instantly as he/she buys any product. But these retailers face a tough challenge maintaining the adequate inventory stocks. They do painstaking forecasting to determine the exact amount of inventories required so that overhead of extra stockpiles can be avoided.
5. When it comes to manufacturing companies, the trouble makers are the account payables. Generally more cash is being consumed than is generated out of such industries.
6. Firms with good market reputation and large market shares have advantage over smaller firms when it comes to obtaining more relaxed, extended and favorable credit terms and conditions from their respective suppliers. The large and old firms get advantage due to past records of their credit worthiness which helps them to keep more cash in hand by delaying payment to creditors and thus maintain high levels of working capital.
7. Some businesses like travelling agents have seasonal peaks. They get money from customers only during some months whereas they incur expenses throughout the year. For such businesses managing of working capital becomes excessively crucial as cash inflows are very limited and seasonal in nature.
Hence, working capital management depends on the kind of firm and its operations. Different firms use different components of working capital for staying in business and managing its cashflow.
IMBALANCES IN AMOUNT OF WORKING CAPITAL
Amount of working capital: Excessive
Excessive working capital means the funds are idle and hence do not contribute to firm’s profit.
It means that too many debtors are present which can lead to bad debts due to improper credit policies.
It also makes it difficult to maintain sound relations with financial institutions.
Excessive working capital leads to decrease in ROI (return on investments) which in turn decreases the share value.
Amount of working capital: Redundant
It leads to avoidable purchases and building up of inventories, thereby increasing the probability of loss, wastage and thefts. http://t1.gstatic.com/images?q=tbn:ANd9GcRCepfqGcG26k8G4x91ZDtVh0j4eSr-l1TtyefM1Sd4il5O6YmD1w
It leads to approximations in transactions.
Due to redundancy, company might finance long-term assets from short term funds. Such kind of a practice is very injurious to company’s health.
Amount of working capital: Inadequate/Shortage
Company fails to pay for its short term liabilities.
Company’s growth is halted as it can no more buy materials and goods in bulk quantities as per its requirements.
Non-availability of cash at the right time hampers company’s capability to take advantage of any favourable market situations.
Day to day operational expenses cannot be met (also disturbs the annual operational targets and plans). This increases the cost of overheads and reduces profits.
Thus, shortage of funds puts the reputation of a company on stake and debars it from getting access to favourable credit terms and policies.
Any such imbalance in the amount of working capital has a heavy negative impact on company’s operational efficiency.
Thus managing of current assets becomes very important to avoid the above discussed imbalances. The finance manager is responsible for taking these important decisions so as to ensure that the following entities are as per the right proportion and quantity as needed by the company:
WORKING CAPITAL MANAGEMENT-INDIA’S PERSPECTIVE
Working Capital Management is a common practice followed in all organizations. Efficient and effective management of working capital becomes an exigent task when it comes to developing countries in Asia (especially India). In countries like India, managers managing working capital devote most of their time in managing and holding cash for their company thereby ensuring all daily needs of their company are fulfilled smoothly. These managers try to strike a balance between the liquidity and the profitability of their firm as adequate liquidity is very essential but too much of it can lead to a decrease in company’s profits.
In India, the need for continuous management of working capital arises due to following reasons:
1. India being a developing country lacks sufficient funds for proper functioning of its economy.
2. Many of the monetary policies are constantly modified and changed to control the ever varying inflation rates of the country.
3. As the country has insufficient funds, there is a heavy burden on banks for loans which lead to high rates of interest.
4. The country is doomed with corruption and black markets prevailing in the crux of its economy as it faces scarcity of goods and services making business firms and general public stockpile.
NEGATIVE REALITY OF WORKING CAPITAL
Till now, the theory says that every company should have positive working capital cycle. While studying the concepts of working capital, I came across the negative reality of working capital. I saw that many flourishing companies of today are having negative working capitals. Companies like Hero Honda Motors Ltd, Dabur India have negative working capital and at the same time are doing very well in their respective markets and have high profits.
Here, I have tried to explain this reality by striking the example of hero Honda Motors Ltd. Although theory does not speaks about this but in practical applications we see that negative working capital is very fruitful to companies and helps in managing its resources well thereby increasing its efficiency, reducing costs and maintaining solvency.
Hero Honda is one of the pioneers in automobile industry. It uses a very efficient approach to management of working capital which can be discussed under the following head:
1. Inventory handling: Hero Honda is using Just in Time approach for handling its inventories. By using Just in time approach, the company reduces its inventory handling costs as the raw materials are brought only when there need arises thus no piles of stocks of raw materials is required. The company is using Supply chain management to reduce the inventory carrying costs of finished goods. The supply chain management streamlines the entire production cycle of hero Honda and delivers products directly to the customers. It also makes the production process efficient and reduces overall costs of production.
2. Accounts Receivables: Hero Honda has adopted DMS (dealers management system) to manage its relations with the dealers (debtors). DMS is an online system that connects the company to its dealers throughout the country. It helps in reducing the time for cash collection from debtors.
Also, the company is using decentralized systems for cash management. This system helps in reducing cost of collecting money from debtors and helps in increasing the working capital as other overhead costs get reduced.
3. Account Payables: Hero Honda is following deferral policy so as to organize and handle its working cost at minimum possible costs. The company extends its credit period by negotiating with the suppliers/bank and manages to keep cash on hand for longer periods. This cash on hand serves as the working capital till it is being used to pay off the debts. All this has been possible because of the goodwill and reputation of Hero Honda which has helped it in getting favorable terms and conditions from the creditors.
The working capital management of Hero Honda is very unique and efficient in itself. The unique characteristics of this management system are:
The company has not taken any short-term loans from banks or other financial institutions. Thus, the company is financing its current assets by using the money which is to be paid to the creditors, i.e. instead of borrowing money for short period, the company is focusing on increasing its credit period to pay off for its debts and is using this money to finance its current assets till the due date for payment arises.
As the company is maintain low inventory levels and at the same time is avoiding short-term borrowings, its current asset’s levels are quite low. On the contrary the company has high level of current liabilities as it seeks to delay payment to creditors, thus making its working capital negative.
The company is following aggressive policy of working capital management wherein the net working capital of company is zero. The company lacks liquidity in the short term but has high profitability.
Thus, the company is doing very well inspite of having negative working capital and no short-term liquidity. Hence, although these theoretical concepts are applicable to real time but in actual practice its not just about following the concepts but it is about doing the right things at the right time. Many external aspects also affect working capital and it is how a company can get the best out of them for its profitable sustenance.
The entire document summarizes the following saying:
It is the shortage of cash which is responsible for failure of many businesses and not the greed for more profits.
The working capital management has two dimensions:
As seen throughout the paper, the key to efficient management of working capital is to strike a balance between time and money. There is a very famous saying-“TIME IS MONEY” and if businesses can optimizes their money flow i.e., use the right amount of money at the right time then there would be no looking back. The entire cycle of cash flow manages money. If the cash flow becomes faster than less amount will be tied up and company will have more money to invest in day-to-day operations and can reduce its borrowings.
Proper working capital management helps in maintaining a good market reputation and goodwill among the customers, suppliers and investors. It not only helps in arranging cash during business turmoil (crisis leading to bankruptcy in absence of immediate cash funds) but also helps in getting loans sanctioned from banks and other financial institutions on company favoring terms and conditions.
Thus, following WCM practices create a very secure, confident environment throughout the company and increase its overall efficiency ensuring that the company maintains its solvency.
From the above studied, the following recommendations can be made to the Working capital management practices at companies:
Cash flow forecasting forms the crux of efficient working capital management. This forecasting must foresee uncertainties in future demands, market slowdowns, loss of repeat customers and unique steps taken by competitors to can harm one’s business.
Working capital management strategic plans must be realistic and must be able to manage risks and act promptly at time of business crisis.
Implementation of working capital management on an organizational basis helps in regulating cash flow throughout all companies/firms within that organization. Cash from one company can be used at others. This kind of a cash-exchange system requires efficient information accessing platforms with good inter-department linkages.
Companies can follow an innovative approach wherein, operational and financial competencies can be combined to form WCM plans which would be capable of generating short term funds of cash. This is only possible when such companies hire personals that perform more than their abilities and set targets to achieve higher levels of performance.
Adopting dispute management practices can also help in reducing the overall operational costs. With such practices, the company officials can reduce disputes by reducing the time of taken to service a customer’s request and decreasing cash collection period.
Customer/supplier collaboration programmes can help in synchronizing their respective demands with the production cycle of the company so that the company maintains minimum amount of inventories.
Thus, working capital management is not only a financial practice rather; it is a benchmark to measure a company’s efficiency. The concept of this management must be included in all activities being practiced by the company which will help in increasing company’s efficiency and satisfaction among its customers.
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