Issues faced in Working Capital Management
|✅ Paper Type: Free Essay||✅ Subject: Finance|
|✅ Wordcount: 5417 words||✅ Published: 1st Jan 2015|
Working capital management holds an important place in the theory of finance. A large number of tools and techniques have been developed in the past to ensure optimal allocation of funds. Various authors have approached the study of working capital management in different ways. A large number of models, theories and techniques (Baumol 1952, Beranek 1963, Haskel Benishay 1965, Haley and Higgins 1973, Walker 1974) have been developed in the past towards the optimal allocation of funds. Efficient use of working capital has a direct bearing on profitability of an enterprise. it increase the productivity of in fixed assets. Basic Survival of a firm may be stake if adequate working capital is not available in time. It is essential to maintain constant supply of working capital for healthy growth of an enterprise.
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Working capital management concerned with current asset and current liabilities. Profitability and liquidity of a company directly affects current asset and current liabilities. So working capital management is considered as most important component of corporate finance. To show the relevance of working capital there are many factors. As far as a typical manufacturing firm is concerned, it accommodates half of its total assets as current assets. More current asset enhances more return on investment. A firm with fewer holdings of current assets would face immense difficulty to carry on the day to day operations of the company (Horne and Wachowicz, 2000).
Efficient working capital management involves planning and controlling current assets and current liabilities in a manner that eliminates the risk of inability to meet due short term obligations on the one hand and avoid excessive investment in these assets on the other hand (Eljelly, 2004). Many surveys have indicated that managers spend considerable time on day-to-day problems that involve working capital decisions. One reason for this is that current assets are short-lived investments that are continually being converted into other asset types (Rao 1989).
With regard to current liabilities, the firm is responsible for paying these obligations on a timely basis. Liquidity for the ongoing firm is not reliant on the liquidation value of its assets, but rather on the operating cash flows generated by those assets (Soenen, 1993). Taken together, decisions on the level of different working capital components become frequent, repetitive, and time consuming. Working Capital Management is a very sensitive area in the field of financial management (Joshi, 1994). It involves the decision of the amount and composition of current assets and the financing of these assets. Current assets include all those assets that in the normal course of business return to the form of cash within a short period of time, ordinarily within a year and such temporary investment as may be readily converted into cash upon need. The Working Capital Management of a firm in part affects its profitability.
The ultimate objective of any firm is to maximize the profit. But, preserving liquidity of the firm is an important objective too. The problem is that increasing profits at the cost of liquidity can bring serious problems to the firm. Therefore, there must be a tradeoff between these two objectives of the firms. One objective should not be at cost of the other because both have their importance. If we do not care about profit, we cannot survive for a longer period. On the other hand, if we do not care about liquidity, we may face the problem of insolvency or bankruptcy. For these reasons working capital management should be given proper consideration and will ultimately affect the profitability of the firm.
Firms should keep an optimal level of working capital that maximizes their total value. Larger inventory preservation might reduce the risk of a stock-out. Keeping large level of inventory and a generous trade credit policy would cause to high sales. Allowing trade credit is most strategic move to stimulate sales. Trade credit would give a chance to customers to assess quality attributes of product before making payments completely or partly (Long, Maltiz and Ravid 1993, and Deloof and Jegers, 1996).
Accounts payable is another most important component of working capital. Investing in account payable or delaying payments to suppliers allow a firm to assess the quality of acquired product before it making its full payments. Investing in accounts payable is treated as inexpensive and flexible source of financing working capital. Bad effect of investing accounts payable is that, it would become loss if the firm offered discount for early or on time payment. Measurement of working capital is most important function of management. A popular measure of Working Capital Management (WCM) is the working capital cycle or operating cycle. This is the time lag between the expenditure for the purchases of raw materials and collecting cash from the debtors. With the reducing of cash conversion period that will be more beneficial to the working capital and it will lead to high level of current asset. As it increases the cash conversion period it will lead to low level of working capital maintenance.
Providing a proper and sound framework for total asset management is most important aspect in financial management practices. Investment in fixed asset would require great level of research activity. Recently, working capital management has been given little attention by researchers relatively. This approach causes great problem for many business firms. Because neglecting of working capital or lazy approach on working capital management would cause utter failure and becomes problematic. Recent corporate history and literature shows that more concerns for working capital management will result in more efficiency. Recent corporate history has got rich set of history for the collapse of firms due to their neglects in working capital management. Altman provided a model called multivariate predictor model based on US companies in the year 1968. In his model he includes working capital as one of the model components. Taffler developed a four-variable model for failure prediction using data drawn from the UK companies in the year 1977.
(Eljelly, 2004) explains that liquidity management involves planning and controlling of current asset and current liabilities in a manner that reduce risk maximum. Major risk in these involves incapability to meet short term obligation as and when it dues. It should also concerns with avoiding excessive investment in current assets. The measurement of relation between profitability and liquidity is most important. To measure this relationship there are many techniques are being used such as ratios and cash conversion cycle. Some companies as in Soudi Arabia was under study as sample. Researchers used correlation and regression technique to study the relationship between profitability and liquidity of certain companies. The study showed that, rather than the ratios such as current ratio and liquidity ratio cash conversion cycle has more relevance to project out the relationship. Another point revealed that size of the companies showed major affect on profitability of various industries. The study revealed certain implications in Soudi Arabian companies. First is that there is negative relationship between liquidity and profitability indicators like current ratio and cash conversion period. Second is that there is variation among companies in terms of measure of liquidity. In spite of all the overall study revealed stable result.
(Ghosh and Maji, 2003) Under this, they take Indian cement companies in to consideration to study in details. They examined and studied the efficiency of working capital management of certain Indian cement companies during the financial period 1992 – 1993 to 2001- 2002. Instead of using the working capital ratios they have used performance, utilization and efficiency indices calculations. Each individual firm has got target efficiency level on the basis of industry norms. And each firm’s speed level of achieving efficiency target is tested under study. Overall study concluded that during particular study period, Indian cement companies did not performed as the targeted as well.
(Deloof, 2003) He explains that, the way that a firm is managing its working capital has significant impact on ultimate profitability of any firms. This is because of the great amount cash investment done by most firms in current assets. He made study by using correlation and regression tools in Belgian firms. During his study he found that there is negative relationship between gross operating income and number of days allowed in account payable, account receivables and inventories of firms. Based on the study he conducted, he concluded that management can reduce the number of days in account receivables and inventory storage reasonably. It will create more value for its shareholders and owners. He also concluded that negative relationship between profitability and accounts payable is due to the reason that less profitable firms take more times to make payment on their bills.
(Shin and Soenen, 1998) To create certain value to owners or shareholders it is important that to mange working capital most significantly and with utter cares. Profitability and liquidity impacted or affected by the way which the working capital management of any firm. There was found a negative relationship between profitability and firm’s Net Trade Cycle by studying the relationship between lengths of Net Trade Cycle. Shorter Net Trade Cycle indicates higher risk associated with stock return.
(Smith and Begemann 1997) emphasized that those who promoted working capital theory shared that profitability and liquidity comprised the salient goals of working capital management. The problem arose because the maximization of the firm’s returns could seriously threaten its liquidity, and the pursuit of liquidity had a tendency to dilute returns. This article evaluated the association between traditional and alternative working capital measures and return on investment (ROI), specifically in industrial firms listed on the Johannesburg Stock Exchange (JSE). The problem under investigation was to establish whether the more recently developed alternative working capital concepts showed improved association with return on investment to that of traditional working capital ratios or not. Results indicated that there were no significant differences amongst the years with respect to the independent variables. The results of their stepwise regression corroborated that total current liabilities divided by funds flow accounted for most of the variability in Return on Investment (ROI). The statistical test results showed that a traditional working capital leverage ratio, current liabilities divided by funds flow, displayed the greatest associations with return on investment. Well-known liquidity concepts such as the current and quick ratios registered insignificant associations whilst only one of the newer working capital concepts, the comprehensive liquidity index, indicated significant associations with return on investment.
Satish B. Mathur (2007), Working capital management contains the proper management and control of the gross current assets. Current asset involves cash, sundry debtors or Account Receivable and inventories. Thus the working capital management relates with the management of all among components not only individually but also collectively, too. Effective management and control of the various components of working capital is one of the most important and vital functions of financial management in any kind of the industrial and business units, based on varied parameters, like flexibility, level of investments in various components of current assets, criticality, quantum of efforts and time. With the help of a method called operating cycle let estimate the duration of one operating cycle. This means time taken by a firm for completing a full cycle of process starting from purchase of raw materials to conversion of finished goods even after sales that, sundry creditors if it is credit sales. The completion of operating cycle has major influence over the profitability of any business concern. So its proper control and management needed to maintain proper working capital.
Vijay Kumar (2001), Funds needed for any business organization for carrying day to day operations. Working capital considered as lifeblood of the business concern. Even though a firm can exist without profit, it cannot survive without working capital fund. A firm which without having working capital fund may cause bankruptcy. The working capital management is the most critical problem in financial management. Most of the time financial executives are devoted towards managing the current assets and current liabilities which are the main constituents of working capital. Importance of working capital management stems from two reasons viz., (i) A substantial portion of total investment is invested in current assets and (ii) level of current asset and current liabilities will change quickly with the variation in sales. Hence, this study makes an attempt to analyze the size, composition, circulation of working capital and whether such an investment has increased or declined over a period of time. Mr. Knight pointed out that not only working capital components are inter dependent on each other but also on net sales and profit. Hence, this study also makes an attempt to evaluate some of the linkage between the different components of working capital and their relationships with the variables like sales, value of output, earnings, cash flow, etc.
One most important area in working capital management is to understand the feature of short run behavior of the demand for working capitals ant its various elements. This study not only includes the cash but also includes the study of demand for receivables, inventories, gross working capital and net working capital.
The concept of working capital, still have some controversies among various financial experts. Working capital has two concepts. They are: the total of current asset and the excess of current assets over current liability. These are called gross concept and net concept respectively. Gross concept is use full when the objective is to measure the size and extent to which current assets are using. Net concept becomes useful when the objective is to evaluate the liquidity position of the concern.
As soon as a firm operate and start to grows it have to make various decisions regarding where to invest and how to invest its various funds, quantity of cash and inventory to be maintained, amount of financing to customers, how to obtain required funds and how much debts can be acquired from outside etc. all those among factors have vital influence in total cash flow and overall profitability of business unit. Working capital management is a crucial decision of how to make structure and finance the operating investment of a business.
Nrendar Kumar Jain (2004), Working capital management has major place in the theory of finance. Optimal allocation of fund is most important face in working capital management. Various tools and techniques have been developed for optimal allocation of fund. Some of them are Baumol 1952, Beranek 1963, Haskel Benishy 1965, Haley and Higgins 1973, Walker 1964. Efficient use of working capital is very much deals with profitability of any business unit. It augments the total productivity of investment in fixed assets. The total survival of a firm will be stuck if working capital not available at time. So it is very essential that to maintain constant and adequate supply of working capital for smooth running and growth of organization.
The term Working capital is represented by current assets. Management of working capital has added significance in the context of any pattern of business weather it is small-scale or medium sized industries in the country. Most of them would have weak financial base and less availability of finance source. If their risk bearing capacity very low there would have an effort to reduce its size releases funds and improves profitability. Working capital management deals with management of current asset such a way that it maximizes the value of firm Both shortage of fund for working capital and uncontrolled over-expansion may cause failure in many business concerns. Especially in small firms, efficiency in working capital management has significant impact in firm’s risk, return and share price.
The financial sector has major role in any economy in mobilization of fund and allocation of savings. Financial sector acts as conduit for transferring financial resources from saver to borrower. Generally banks act as an integral part of financial sector.
Working capital management can be say as a process of planning and controlling the level and proper mix of the current asset of the firm. It includes financing of these assets in the organization. Here financial manager has to decide what quantities of cash, liquid assets, bills receivable and inventories have to be hold at various times. Financing of current asset is next important decision to be taken by a finance manager. Choice for financing these assets includes mix of current as well as long term liabilities.
There are two important implications for the management of working capital. First to choose management, working capital can be acquired to meet immediate needs when they arise. A hand-to-mouth policy like this has an advantage of reducing the average investment in working capital. So they can minimize interest charge, insurance expense and storage fees necessary to carry the investment. In spite of this, hand-to-mouth policy has certain disadvantages also. There will be increased ordering cost associated with greater likelihood that the firm may experience storage in working capital. The reason behind this is that, there is no buffer stock to absorb unexpected functions.
Management of working capital is faced by two basic questions. First is that the level of sales and relevant cost, what quantity of cash, receivables and inventories a firm should keep in optimal. Second is that the most economical way to finance these working capital investments. To have best return on investment firm should not keep unproductive assets and it should finance in cheep source of fund. Literally, it is always better that to invest with short term asset and with short term liabilities.
Eugene F. Brigham, Joel F. Houston (2009), Working capital management involves search the optimal level of cash, bills receivable, marketable securities and inventories. It includes financing the working capital with least cost. Since most of the buyers using credit cards that neither in-store cash nor bills receivables, best buy are working capital policy focuses on its inventories as well. To keep non interrupt sales its store must be stuffed with adequate materials. Whenever the customers needed the goods they should able to supply it. This relates with deciding what product is more latest and trendy and obtaining hot product with cheep cost and supply to stores.
Miraculous development in the field of technology and communication has been changed the entire scenario. The way of managing its inventories is in best way now. Now, real time data is collecting from various stores and departments. Whenever there is a need for inventories and need for outsourcing of inventories, the computer system places the order automatically. In short, incoming and outgoing of inventories are done by the computer packages. If sale of an item is slipping, prices are lowered to reduce stock of that item before the case getting worst.
Eugene F. Brigham, Michael C. Ehrhardt (2008), Working capital is excess of current asset over current liabilities. Firms are using different kind of policies to manage its working capital as well. Some firm uses relaxed working capital policies and some sues restricted policies.
A relaxed working capital policy is that firm keeping large amount of cash and inventories relatively. Here sales are stimulated by the use of credit policy that providing finance to customers very liberally. And the company doesn’t take advantage of credit provided by bill payables and accruals.
In restricted working capital policy cash, inventories and receivables kept in very low quantity relatively. Here accruals and payables are maximum and NOWC is turned over more frequently. Optimal and moderated working capital policy is between these two extremes.
Under the certainty condition, firms keep minimum level of working capital because, sales, cost and payment periods are certain. A large amount will increase the need for external funding without a corresponding increase in profit. Under the situation of uncertainty the picture is completely different. Here the firm must have to maintain a minimum level of cash, inventory. Here the quantity of keeping of working capital would be based on expected sales, expected profit, expected time and so on. Account receivables are determined by credit terms of the business as well.
Shashi K. Gupta, Neeti Gupta (2008), Working capital in general practice refers to the excess of current asset over current liabilities. Management of working capital therefore, is concerned with the problems that arise in attempting to manage the current asset, the current liabilities and their inter relationship that exist between them. In other words it refers to all aspect of administration of both current assets and current liabilities.
The basic goal of working capital management is to manage current asset and current liabilities of a firm in such a way that satisfactory level of working capital is maintained. That means it is neither inadequate nor excessive. This is so because both inadequacy and excessive position are bad in any kind of organization. Inadequacy of working capital will lead to insolvency and excessive working capital will lead to idle fund which earn no profit for the business. Working capital management policy has important impact in success of a business.
In the word of ‘Shubin’, “working capital is the amount of funds necessary to cover the cost of operating the enterprise.”
According to ‘Genestenberg’, “circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivables to cash”
2.1 MEANING OF WORKING CAPITAL
Working capital refers to short term fund to meat operating expenses. To quote great Indian financial analyst and scholar Mr. Ramamoorthy, “it refers to the funds, which a company must possess to finance its day to day operations”. It is concerned with the management of the firm’s current asset and current liabilities. It relates to with the problems that arise in attempting to manage current assets, current liabilities and their inter relationship that exist between them. If a firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.
Working capital refers to that part of a firm’s capital which is required for financing short-term or current assets such as cash, marketable securities, debtors and inventories. Funds, thus, invested in current assets keep revolving fast and are being constantly converted into cash and these cash flows out again in exchange for other current assets.
Hence, it is also known as ‘revolving or circulating capital’ or ‘short-term capital’.
In the words of Shubin, “Working capital is the amount of funds necessary to cover the cost of operating the enterprise.”
Types of working capital
Net working capital or qualitative
Net working capital or qualitative
Temporary or variable working capital
Gross working capital or quantitative
Gross Working Capital
According to this concept, the total current assets are termed as the gross working capital or circulating capital. Total current asset include; cash, marketable securities, account receivables, inventory, prepaid expenses, advanced payment of tax. This concept also called as quantitative or broad approach. To quote Weston and Brigham, ” Gross Working Capital refers to firm’s investment in short term assets such as, cash, short term securities, account receivables and inventories “. The concept helps in making optimum investment in current assets and in their financing.
According to Walker, “use of this concept is helpful in providing for the current amount of working capital at the right time so that the firm is able to realize the greatest return on investment”.
Gross working capital concept focuses attention on the two aspect of current asset management. They are:
1). Optimum investment in current assets:
Investment in current asset must be just adequate to the needs of the firm. On the other hand excessive investment in current asset should be avoided.
2). Financing of current asset:
Need for working capital arise due to the increasing level of business activity. Therefore, there is a need to provide it quickly. If there is surplus fund arise that should be invested in short term securities.
Net Working Capital Concept
As per this concept the excess of current asst over current liabilities represents net working capital. Similar view is expressed by Guttmann, Gerstenberg, and Goel Etc.
Net Working Capital represents the amount of current asset which remain after all the current liabilities were paid. It may be either positive or negative. It will be positive if current asset exceed current liabilities and vice versa.
To quote Roy Chowdry, “Net Working Capital indicates the liquidity of the liquidity of business whilst gross working capital denotes the quantum of working capital with which business has to operate.
Net Working Capital Concept focuses on two aspects. They are:
1). Maintaining liquidity position:
Excess current assets help in meeting its financial obligation within the operating cycle of the firm. Negative and excess working capitals both are bad to the firm.
2). to decide upon the extent of long term capital in financing current asset:
Net working capital means the portion of current asst that should be financed by long term funds. This concept helps to decide the extent of long term fund required in finance current assets.
Permanent Working Capital
This is the minimum investment kept in the form of inventory of raw materials, work in process, finished goods, stores and spares and book debt to facilitate uninterrupted operation in a firm. Though this investment is stable in short run, it certainly varies in long run depending upon the expansion programs undertaken by the firm. It may increase or decrease over a period of time.
Temporary Working Capital
Any additional working capital apart from permanent working capital required to support the changing production and sales activities is referred to as temporary working capital. A firm required to maintain an additional amount current asset temporarily over and above permanent working capital.
PRINCIPLES OF WORKING CAPITAL MANAGEMENT / POLICY
The following are the general principles of a sound working capital management policy:
Principle of Risk Variation
Risk here refers to the inability of a firm to meet its obligation as and when they become due for payment. Larger investment in current assets with less dependence on short-term borrowing increases liquidity reduces risk and thereby decreases the opportunity for gain or loss. In other words, there is a definite inverse relationship between the degree of risk and profitability. A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management assumes greater risk by reducing working capital. However, the goal of the management should be to establish a suitable tradeoff between profitability and risk.
Principle of Cost of Capital
The various sources of raising working capital finance have different cost of capital and the degree of risk involved. Generally, higher the risk lower is the cost and lower the risk higher is the cost. A sound working capital management should always try to achieve a proper balance between these two.
Principle of Equity Position
The principle is concerned with planning the total investment in current assets. According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position.
Principle of Maturity of Payment
This principle concerned with planning the sources of finance for working capital according to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Maturity patterns of various obligations are an important factor in risk assumptions and risk assessments.
Importance of working capital management:
To maintain sound working capital position is critical and important function for any management. Because the success of business is very much depends on how they manage its working capital. It should keep preserve a sound working capital position by avoiding excessive investment and keeping adequate working capital to meet daily operations.
. As pointed out by Ralph Kennedy and Stewart MC Muller, “the inadequacy or mismanagement of working capital is one of a few leading causes of business failure. Current assets, in fact, account for a very large portion of the total investment of the firm”.
Determinants of Working Capital:
Working capital requirements of different firms are different. Each firm has own manner to operate with. They would require current asset and current liability as per their type of operation and way of operation. So it is main function of working capital management to determine the level of working capital required. Even though there are no specific set of determinants to decide about working capital, there are some determinants which have been using commonly by the management. They are discussed under:
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1). Size of business operation:
Size of the business is varying business to business. Size is another most important factor to be considered while determining working capital requirements. Here the size of the business is measured in terms of operation doing by business and not on physical evidence. The amount required as working capital is direct proportion with size. That is if the size of business is large it would require more working capital and it is small it would require less amount of working capital to invest.
2). Nature of business activity:
There are some firms which requires very short amount to be invested in fixed asset and more in current asset. Likewise, some firms would require more investment in fixed asset and less in current asset. This is why the nature of business comes more significant while determining the working capital. Trading and financial type of companies would require to invest more in current assets. So while determining the level of working capital investment it should be based on nature or type of business.
3). Business Fluctuations:
Demand for the products of each business is fluctuating season to season. So each business has to be made financial planning in advance to have seasonal working capita
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