Quick Revision: Basics Of Working Capital Management

Basics Of Working Capital Management:

 

 

Working Capital

Any firm, from time to time, employs its short term assets as well as short term financing sources to carry out its day to day business. It is this management of such assets as well as liabilities which is described as working capital management.

OR

Working capital management refers to a company’s managerial accounting strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities, to ensure the most financially efficient operation of the company. The primary purpose of working capital management is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.

 

Form of working capital:

Cash——-Inventories——-receivables——cash

 

Terms of working capital:

  • Net working capital:

NWC= Current Assets- Current Liabilities

 

  • Permanent Working Capital:

Minimum amount that must remain invested to carry out day to day business. Some amount of cash, stock and or account receivables are always locked in. Such funds are drawn from long term resources.

 

  • Variable Working Capital:

Working Capital requirements  of a business firm might increase or decrease from time to time due to various factors. Such funds are taken from short term resources.

 

  • Gross working capital= Sum of all Current assets

 

 

 

Objectives of Working Capital Management:

 

  1. To maintain the working capital operation cycle and to ensure its smooth operation
  2. To mitigate the cost of capital
  3. To maximise the return on current assets investment.

 

Working capital Cycle:

It refers to the minimum amount of time which is required to convert net current assets and net current liabilities into cash.

 

Cost of capital:

The cost of capital is the minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price.

 

Components of working capital cycle:

  • Cash: Maintaining a healthy level of liquidity is always good practice. It is extremely important to maintain reserve fund.
  • Inventory: Not too large, not too small. A balanced inventory.
  • Creditors- Acc. Payable

Debtors- Acc. receivable

 

 

Properties of healthy working capital cycle:

  • Has to be sourcing of raw material.
  • Production planning should be intact.
  • Quick selling of finished goods.
  • Timely payout and collections
  • Maintain healthy liquidity.

 

Approaches to WCM:

  1. Conservative approach: It involves low risk and low profitability. Both Permanent working capital and the working capital is financed from the long term finance.
  2. Aggressive approach: The main goal is to maximise profit. Entire working capital,  fixed capital all are financed through short term source..
  3. Moderate approach:
Fixed assets Long term
Permanent working capital Long term
Variable working capital Short term

 

Signature of adequate working capital:

  1. Sufficient liquidity.
  2. On time payment
  3. A good credit history
  4. Ensure dividends are regularly paid.
  5. Ensure an uninterrupted flow of production.

 

Factors for determining the amount of working capital needed:

  1. Nature of business: a banking industry require more WC., Public utilities require less WC.
  2. Term of purchase and term of sale.
  3. Size of business units is proportional to requirement of WC.
  4. Turnover of inventories is another factor.
  5. Process of Manufacturing
  6. Importance of labour

 

 

 

 

 

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