Essay: Working capital

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  • Working capital
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Working capital is described as the lifeblood of a business as it shows the liquidity of a business. It is the amount of capital that a business needed to meet its day-to-day operation. Working capital consists of current assets and current liabilities. It is the amount of current assets that more than current liabilities. It is also called revolving or circulating capital or short-term capital.

Working capital is calculated by current assets minus current liabilities. Current assets are the assets that can be turned to cash within or less than one year, such as inventory, cash, bank, bill receivables, short-term investments, etc. Current liabilities are the obligations, which should be paid to creditors within or less than one year at their maturity, such as bank overdraft, bill payables, short-term loans, etc.

Working capital management is essential in financial management. An efficient working capital management may help in the financial operation of a firm and improve its earning and profitability. It is the management of current assets and current liabilities which include inventory, accounts receivables, and account payables as well as the relationship between them. Decision making which relating to working capital is also referred to as working capital management.

The purpose of working capital management is to maintain a sufficient amount of working capital to run the business as too high level of working capital would reduce the profitability of firm and too low working capital level would lead a firm to go into liquidation. It makes sure the firm has enough monetary liquidity to meet its short-term debt obligations and operating costs to ensure a reasonable margin of safety. In other words, it ensures that there is always sufficient cash on hand to pay for liabilities as they come due for payment and to satisfy the upcoming operational expenses.

Objective of Working Capital Management

The objective of working capital management is to ensure that the firm has sufficient money for short-term debt and upcoming expenses. In other words, the right ratio of assets, liabilities and working capital must be maintained by the company. There are few objectives of working capital management which are:

Maintaining the working capital operating cycle and ensuring its smooth operation

The fundamental of business operations is to maintain the cycle running smoothly. The operating cycle refers to an enterprise’s whole life cycle. Management of working capital attempts to ensure the smoothness of cycle starting from the procurement of raw material to the smooth production and delivery of the finished goods.

Lowest working capital

The net working capital should be in equilibrium. The working capital ratio should be optimized as the lower working capital indicates the risk of distraction of operating cycle and the higher working capital means the interest cost is higher. The lower ratio implicates that the company is unable to pay its current debts because of the level of current assets is low.

Minimize rate of interest or cost of capital

Working capital management focuses on minimizing the cost of capital in order to achieve higher profitability. The interest rates should be negotiated with the bank if the working capital investment involves bank finance. The way of minimizing capital cost is utilizing the long-term funds but in a proper mix. The fundamental principle of financial management should be observed seriously when deciding on the financial mix. The principle states that long-term sources of funds of same maturity should be used to finance fixed assets and permanent assets whereas short-term sources of funds should be used to finance short-term or temporary assets.

Optimal return on current asset investment

The return on investment in the current assets must exceed the weighted average cost of capital so that the owners’ wealth maximization can be ensured. This means that the rate of return received from investment in current assets should be more than the cost of capital or rate of interest. The purpose of working capital management is to gain maximum return from an investment in current assets to ensure higher profitability.

Determinants of Working Capital

Nature of business: Public utilities or service industries require low amount of working capital due to the selling of service rather than goods whereas the manufacturing or trading firms need relatively large amount of working capital together with their fixed investment of inventories.

Size of business: Small business need less working capital compared to big business concern which has to maintain high level of working capital for the purposes of paying current liabilities and investment in current assets.

Production policy: Company which reduces the level of production in off season will definitely decrease the amount of working capital. The company which continue its production process in off season will certainly require more working capital.

Credit policy: The business require large amount of working capital to finance its debtors if purchase the goods on cash basis but sell on credit term. Less working capital is needed if the goods are bought on credit term but sold on cash basis.

Growth of business: Working capital required will increase to meet its expansion need if the business is growing rapidly. If the business is shrinking, it will result in a decrease in the requirement for working capital.

Price level changes: Rising in the product prices will certainly increase the amount of working capital needed by the company because it requires more funds to purchase the materials.

Dividend policy: The firm require less working capital if it has more retained profits for dividend payment whereas the firm which lack of reserve has to invest large amount in working capital.

Business cycle: Low amount of working capital is required by the business during recession. However, economic prosperity creates demand for high level of working capital in order to develop the business.

Manufacturing cycle: The firms require more working capital if the manufacturing cycle is longer due to its complicating process of making finished goods. The lesser time involved in manufacturing process will reduce the level of working capital required.

Turnover of circulating capital: The faster the cash is recovered by the sale of goods will reduce the demand for working capital whereas more working capital is needed in case of slower turnover.

Operating efficiency: The operating efficiency is arising from the efficacy in optimum utilization of assets and the controlling of operating costs. More funds will be released for working capital due to the optimal utilization of assets.

Seasonal variations: Some businesses produce the goods seasonally only which lead to the requirement of more working capital in order to purchase the raw materials in bulk during the season.

Advantages of Adequate Working Capital

The company is able to make prompt payments to its creditors on time which in turn helps in maintaining and creating the financial reputation or goodwill of the business.

The business can benefit from favourable financing terms such as avail cash discount or trade discount on purchases from suppliers and hence the costs can be reduced.

Sufficient working capital result in high solvency and excellent credit standing which can facilitate the arrangement of loan facilities from banks and other financial institutions on easy and favourable terms.

A firm which has ample working capital can finance its day-to-day commitments and hence it will create efficiency in the business and improve the overall profits.

It ens
ures uninterrupted supply of raw materials when required and continuous flow of production to satisfy customers’ orders or demands.

Sufficient working capital will help the company to encounter the business crises during depression and the unpredictably large amount of orders or peak demand.

Company with sufficient working capital can take advantage of new business opportunity to expand or grow its business and thus prevent the business from failure.

A business concern is being able to offer a credit line to its customer which can encourage them to buy more instead of purchase from the competitors.

Adequacy of working capital eases the repayment of loans and dividends to the investors quickly. This will increase the confidence of investors and facilitate the raising of additional funds in the future.

The company can exploit favorable market conditions easily such as buying the materials in bulk when prices are lower and undertake the profitable projects.

Disadvantages of Excessive Working Capital

Excessive working capital means ideal funds in the business which earn nothing. Thus the rate of return on its investment falls which will automatically affect the goodwill of the company. Lower rate of return may cause the share value and share price fall.

Redundant working capital implies too much receivables and defective credit policy which may increase the level of bad debts and adversely affect the overall profitability of the business.

The excessive working capital gives rise to speculative transactions which in turn may create more wastage of money or losses for the business.

Surplus of cash tempts the managers to expend more and redundancy of working capital may lead to overall inefficiency of the management in the company.

It may lead to accumulation and unnecessary purchase of inventories in bulk which may bring about losses or wastage and increase in storage costs.

The company may not be able to maintain its relationships with the banks and other financial organizations.

Extra working capital will destroy the control of turnover ratios which is normally used in running an efficient business. It also destroys all other guides and sign posts in conducting the business.

Levels of Working Capital

Working capital policy is a policy of the firm about its working capital and how its working capital should be financed. Organizations have to make a decision on the amount of money to be kept in cash account, the level of inventory to be maintained, the amount of receivables that allowed to build up and the risks related to working capital. There are three methods of working capital policy which are conservative, aggressive and moderate approaches.

Conservative Working Capital Policy

A conservative working capital management policy aims to minimize the risk of system breakdown by maintaining a higher level of working capital. The company which has a greater net working capital is at a comparatively low risk position. With this policy, the company can achieve the targeted revenue through the estimation of current assets, which is prepared after taking into account the uncertain events. This policy is suitable for manufacturing operations to meet seasonal variations such as a sudden change in the activities level.

Such a policy maintains a larger cash balance, perhaps even invests in short-term securities. Customers are offered more generous credit terms to increase demand. The company will hold a higher level of inventories to reduce the risk of stock-outs and to meet customer’s requirement. Prompt payments to suppliers can ensure the reputation of company and decrease the chances of running out of stock. This policy result in a lower risk of inventory or financial problems but it will decrease the profitability of company.

However, the adverse effect on this policy is the high burden of unproductive assets carried by the firm may lead to a financing cost that can affect the profitability of business. Severe cash flow problems may arise from a rapid expansion as the available finance is insufficient to meet the working capital requirements. Lack of responsiveness to customer demands and inventory obsolescence can also cause a lot of problems.

Aggressive Working Capital Policy

An aggressive working capital management policy intends to decrease an organization financing cost and increase profitability. With this policy, an organization will speed up its business cycle to increase sales and revenues. Adoption of this policy bring about the benefit of lower working capital requirement due to the low investment in current assets. As the company has a lower net working capital, it is profitable but very risky. The company holds a lower level of inventories in order to reduce costs but the chances of system breakdown by way of running out of stock will increase or loss of goodwill.

However, modern manufacturing techniques such as just-in-time system and total quality management encourage the reduction in inventory and work in progress as well as the improvement in products quality. The company only produces goods when receiving orders from their customers. The goodwill of company will increase since it can fulfil the customers demand. The customers do not care about the shorter credit term given as long as the company can provide a good quality and effective response to customer demand.

Moderate Working Capital Policy

A moderate working capital management is a balance between the aggressive and conservative approaches. It undertakes the characteristics of both policies. These characterizations can help in contrasting and analyzing the different ways of working capital management in which the individual company deals with and the trade-off between risk and profitability.

This policy presume the risk and profitability is moderate which greater than conservative but lesser than aggressive approaches. With this policy, a company has moderate level of net working capital, for example the liquidity of company is balanced since it can maintain an adequate level of cash. When the level of cash is high, the company has extra cash to invest in liquid short-term investment for the purpose of generating additional profit.

Permanent and Fluctuating Current Assets

In order to analyze the financing decisions of working capital, assets can be categorized into three different types which are non-current assets, permanent current assets and fluctuating current assets.

Non-current assets are the long-term assets from which the assets are expected to generate economic benefits more than one accounting period and it must be depreciated over their useful life. For example, office building or motor vehicles.

Permanent current assets represent the minimum level of current assets required by the company to support its normal trading activities. In other words, the company needs to maintain the base of inventory level, cash and account receivables that is necessary to meet long-term minimum requirements.

Fluctuating current assets refer to the current assets which fluctuate with the changes in normal business activity, for instance as a result of seasonal fluctuations and production or sales level. It can be considered as an additional working capital, over the permanent working capital which is required to sustain the normal business activities changes.

Parts of the working capital are formed by fluctuating current assets and permanent current assets. They may be financed by either short-term funding such as current liabilities or by long-term funding such as equity capital.

Working Capital Financing Policies

There are three methods of working capital fi
nancing policies which can help an organization to make decision based on the analysis of such policies. Three of these policies are conservative, aggressive and moderate financing policy.

Conservative Financing Policy

This approach not only finances all the non-current assets and permanent current assets, but also some part of fluctuating current assets with long-term debt and equity. It is a low risky and low profitable policy. The company is more reliance on long-term borrowing as it is relatively less risky. Before repayment is due, borrower has more time to utilize the loan proceeds. The borrower will not be affected due to the fixed interest rate even the interest rates spike up during the loan period.

Nevertheless, long-term funding is normally more costly than short-term financing. Profitability is reduced because of the higher rate of interest costs associated with long-term financing or investment line. The heavy usage of long-term finance will result in a higher liquidity, therefore it can take benefits of sudden chances or opportunities. The risk of bankruptcy is minimized as the liquidity is maintained at a higher level.

Aggressive Financing Policy

This policy finances the working capital with high risk and high profitability. The company uses long-term debt to finance all its fixed assets and a portion of its permanent current assets. The remaining part of permanent working capital and all the temporary working capital are financed by short-term funds.

In this policy, most current assets are financed by short-term borrowing. The greater usage of short-term financing is more risky because of the fluctuation of interest rates but it offers higher returns. This policy carries a higher risk of liquidity and cash flow problems in terms of saving in the long-term finance cost which conversely will produce higher profitability. As the company has greater dependability on short-term finance, it will result in lower liquidity. An extremely tight liquidity level being maintained may cause the risk of bankruptcy to be increased.

Moderate Financing Policy

The moderate approach is a middle way between the conservative and aggressive working capital financing approaches. It is also known as matching financing policy. It involves the use of long-term debt and equity sources to finance non-current assets and permanent current assets whereas the fluctuating current assets is financed with short-term debt.

This policy defines the maturity of the sources of finance should match the maturity of different types of assets. It means the expected life of funds raised to finance assets is equivalent to the expected useful life of the assets. For example, a five year loan may be raised to finance motor vehicle with expected life of five years. In short, the moderate financing policy finances the working capital with moderate risk and profitability.

Summary:

Policy Conservative Aggressive Moderate

Liquidity Higher Lower Medium

Risk Lower Higher Medium

Profitability Lower Higher Medium

Overtrading (Undercapitalisation)

Overtrading refers to a situation where a business entity is operating with inadequate long term capital to support the current volume of trading, raising the risk of liquidity problems. Overtrading occurs when a business is accepting work, and trying to complete it at a level that can’t be supported by its net current assets or working capital. The business have insufficient cash and can’t obtain enough cash promptly. Overtrading arises even though the business entity is making a profit. Over-expansion of business is one of the main reasons for overtrading and therefore overtrading is also known as under-capitalization. Overtrading is particularly common in young as well as fast growing businesses.

Symptoms of Overtrading

Sales increased rapidly.

Increase in receivables.

Inventory movement is unusual.

Current and quick ratios decreased.

Accounts payable period increased.

Profit margin and cash balance declined.

Short term borrowing and gearing ratio increased.

Ways to Overcome Overtrading

Restrict or slow down the expansion of business.

Injection of new capital by issuing new share capital or obtaining long-term loans.

Establishing new payment terms with debtors for future orders.

Offering discounts for prompt payments will boost cash flow and reduce bad debts.

Negotiating payment terms with suppliers to grant longer payment terms.

Reduction of cost will improve cash flow and reduce the risk of overtrading.

Lease or hire purchase non-current assets will help smooth cash flow.

Improve inventory control as faster inventory turnover will reduce the time between customer payments and paying suppliers for goods.

Undertrading (Overcapitalization)

Undertrading is also called over-capitalization and it is the opposite of overtrading. Undertrading refers to a situation where a business entity has excessive working capital than it catered-for or needs. It will lead to a low return on investment if there are excessive inventory, receivables and cash, and very few payables, with long-term funds tied up in non-earning short-term assets. Undertrading arises when the company’s actual profits are insufficient to pay interest on debentures and borrowings and a fair return to shareholders over a time period. It is said to be over-capitalized when it fixed and current assets less than the total of owned and borrowed capital i.e. when the assets side of the balance sheet exhibits accumulated losses.

Symptoms of Undertrading

Volume of sales declined.

A high level of inventories.

Return on capital employed is low.

Excessive current and liquid ratios.

Taking shorter credit period from suppliers.

Receivables collection period being too long.

Ways to Overcome Undertrading

Idle assets can be sold for cash.

Reduction of debt obligation by negotiating with creditors.

Redeem preference shares through capital reduction scheme.

The par value and paid up value of equity shares can be reduced.

Returning the funds to the investors by distributing the cash as dividends.

Find new investments which provide a satisfactory return with the excess cash.

Bringing down the values of the assets to their proper values by removing the over-valuation policy.

A satisfactory relationship between proprietary funds and net profit can be obtained by reduction in its capital.

Cash Operating Cycle

The cash conversion cycle (CCC) measures the number of days from the beginning of the production process to receive cash from the sale of that product. In other words, the cash conversion cycle calculation measures how long cash is tied up in inventories and accounts receivables or the number of days between disbursing cash and collecting cash. CCC also called working capital cycle or cash conversion cycle. CCC is also used to measure the liquidity or the effectiveness of a firm’s working capital management. The diagram below shows how the cycle works:

Calculating the cash operating cycle:

This cycle is the average length of time (measured in days) between the payment for purchases of raw materials and collection from trade receivables.

Inventory Holding Period (Days) (Stock Days)

A measure of how long on average a business holds inventories before being sold. It is known as the inventory turnover period which is the a
verage length of time between the purchase of raw materials and time taken to pay creditors who have supplied goods and services on credit.

=(Closing Payable)/(Average Purchase per day)=(Account Payable)/(Annual Purchases)×365 days

It shows the liquidity of inventories, the higher the turnover indicates that the inventories are ‘bought and sold’ quickly throughout the year. If the turnover is lower, it indicates that the company is taking a longer time to sell the product. It is beneficial for a company to hold its inventories in a short period of time. If company can sell its inventory quickly, less cash will be tied up and it is possible to generate more profits. The company should hold a moderate inventory level.

Receivables Collection Period (Debtors Days)

It indicates the number of days on average that the customers are taking to pay. It is calculated as account receivable divided by the average credit sales per day.

=(Closing Receivable)/(Average Sales per day)=(Account Receivable)/(Annual Sales)×365 days

Short collection period is usually preferred because the liquidity of the company may improve and it is better for the company’s financial position. In addition, it will decrease the risk of bad debts and administration costs on collecting receivables. The collection period depends on the credit terms allowed by the company.

Payables Payment Period (Creditors Days)

It indicates the average number of days that the company is taking to pay its creditors who have supplied goods and services on credit. If purchase figure is not available, use cost of sales.

=(Closing Payable)/(Average Purchase per day)=(Account Payable)/(Annual Purchases)×365 days

A company should not take too long period to repay its payables, it may indicate the liquidity problem as the company may not have enough funds to pay their credit suppliers on time. Therefore, the reputation and creditworthiness of the company may be affected.

Cash operating cycle and working capital requirement

The working capital cycle is aimed in deciding the minimum amount of working capital required by a company in operation. The three elements in the cash operating cycle is not overmuch nor too small.

An excessive working capital means a larger investment in current assets and need more capital to finance it. For instance, longer time to receive payment from receivables.

The shorter working capital cycle is better for the company as the inventories are not held in hand for a longer period, payment from trade receivables is accelerated and the maximum credit can be obtained from the suppliers.

Cash Operating Cycle: Example

Extracts from the statements of financial position and income statement of a company are set out below.

RM

Annual purchases 2 745 000

Annual cost of sales 6 272 128

Annual sales 6 802 400

Inventories:

Raw materials 964 000

Work in progress 548 128

Finished goods 2 567 893

Trade receivables 2 425 600

Trade payables 704 800

Required: Calculate the length of the cash operating cycle for the company.

ANSWER:

Items Days

Raw material turnover (964 000/2 745 000) x 365 days 128

Production cycle (548 128/6 272 128) x 365 days 32

Finished goods turnover (2 567 983/6 272 128) x 365 days 149

Credit period given to customer (2 425 600/6 802 400) x 365 days 130

439

Minus:

Credit period from supplier (704 800/2 745 000) x 365 days (94)

Credit operating cycle 345

Before the company gets paid the cash from the sales, it takes 345 days on the average from paying suppliers for goods.

LIQUIDITY (WORKING CAPITAL) RATIO

Liquidity means having cash or access to cash to meet liabilities and manage its working capital. Normally a higher ratio indicates a better liquidity.

Two ratios for measuring liquidity are:

Current ratio

The current ratio is the ratio of current assets to current liabilities. It measures the capacity of a company to pay its current liabilities with its current assets. It can be calculated as follow:

(Current assets)/(Crurent liabilities)×365 days

A high current ratio indicates that a company is able to meet its short-term debts repayment and more liquid. Examples of current assets include cash and cash equivalents, marketable securities, short-term investments, accounts receivables, and inventories. “Rule of Thumb”; a ratio 2:1 is considered desirable in most sector, however current ratio should not be lower than 1:1.

Examples:

2007(RM) 2006(RM)

Current ratio 496/552=0.90 404/202=1.84

(Figures assumed)

The current ratio has deteriorated in year 2007. For every RM1 owing as current liabilities, there is RM0.90 of cover provided by the current asset. It has come down to RM0.90 in year 2007; liquidity position of the company is getting worse which may indicate cash flow problems.

Acid Test Ratio (Quick Ratio)

It measures of how well a company is paying its current liabilities when they come due with only quick assets. It can be calculated as follows:

(Current assets-inventories)/(Crurent liabilities)×365 days

It is a ratio of liquid asset which the inventory is excluded in the calculation as the inventory is a slow-moving item and it takes a longer time to convert into cash. “Rule of thumb”; it should be 1.0 or higher. In the event of liquidation, the company can pressure the debtor to pay quickly and sell any short-term speculation within a short period of time.

Example:

2007(RM) 2006(RM)

Acid Test Ratio (496-364)/552=0.24 (404-202)/220=0.78

(Figures assumed)

Ratio 0.24 indicates poor liquidity in year 2007. The potential new supplier is more likely to restrict the credit amount or even refusal of any credit at all.

CONCLUSION

In a conclusion, a well management in working capital is important and the working capital can be considered as key factor in a firm’s long-term success. An ineffective management in working capital may cause the business failure.

There must be an effective working capital management to make sure the firm has enough working capital to cover its debts and obligations in order to make the business runs smoothly and operates continuously. Therefore, the firm should decide which types of working capital polices and financing polices should be adopted as these policies may result in different level of risk, liquidity and profitability.

A good management in working capital will enhance the liquidity, solvency, creditworthiness and also the good reputation of the firm. We can say that it helps in avoiding the possibility of over-trading and under-trading. In addition, minimization in the risk of bankruptcy and maximization in the return on current assets investments will also be resulted from an effective working capital management.

Other than that, the financial stability of a firm can be measured by current ratio, quick ratio and working capital cycle ratio. Working capital management is really useful for a firm as it helps the firm to ensure the working capital is used in the productive way and also to ensure the business is operated in an efficient way.

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