WORlCIBG CAPITAL MAIaK-

The management of current asse ts and current

l i a b i l i t i e s and the i n t e r relationehlp t h a t exis to

between them may be tenasd ae working capi ta l manage-

ment.' It is a l s o known as current asse ts management

because it requires much of the f inancia l managervs

time. It is concerned with the problems t h a t a r i s e

i n attempting t o manage the current assets, the current

l i a b i l i t i e e , and the i n t e r relationship t h a t ex i s t

between them.2 I t involves the administration of shor t

t e n a s se t s l i k e cash, marketable secur i t ies , accounts

receivables and inventories. Technically it i s an

in t eg ra l p a r t of the f inancia l management, and it

attempts t o manage and control the current asse ts and

the current l i a b i l i t i e s i n order t o maximise the

p r o f i t a b i l i t y and ensureproper l i qu id i ty i n the

business. Liquidity and P ro f i t ab i l i t y a re two important

and major aspects of business l i f e . No firm can survive

i f it has no l iquidi ty . A f i n may even e x i s t without

making p r o f i t s but cannot survive without l iquidi ty .

1. James, C. Von Home, Financial Management and Policy, Prentice Hall of India, New Delhi, 1973, p.384.

2. Smith, K.V., uanaqement of Working Capital , West publishing Co., New York, 1974, p.5.

The manner of management of working capi tal t o a

very large extent betennines the success of opera-

t ions of a concern. Though, often business fa i lu res

have been at t r ibuted t o lack of working capi tal , i n

the ultimate analysis it is the mismanagement of

working cap i ta l t h a t w u l d have converted an other-

wise successful business i n t o an unsuccessful onee3

The proper management of working capital is very

important f o r the succems of an enterprise and tha t

i s why it has become a basic and broad measure of

judging the performance of a firm.

WEAHING OF WORK= CAPITAL

Working capital, i n eimple terms, is the

amount of funds which a company must have t o finance

I t s day t o day operations. It can be regarded as

t h a t proportion of canpany8s t o t a l capi tal which is

employed i n short term operation^.^ I t represents the firm's investments i n cash, marketable securi t ies ,

arrounts receivables and inventories l e s s the current

l i a b i l i t i e s used t o finance the current assets. Some

3. N.K. Agrawal, Manaqement of Workinq Capital, Ster l ing Publishers (Pvt.) Ltd . , New Delhi, 1983, p.8.

4. Remamoorthy, V.E., Workinq Capital Manaqement, I n s t i t u t e fo r Financial Management and Research, Madras-34, 1978, p.5.

r e f e r to t h i s masure a s ne t working capital . But

according t o Waston and Copeland, i f working capi ta l

is what is l e f t a f t e r taking account of current

l i a b i l i t i e s it is redundant t o add the term "netn.

Working Capital Managanent is defined broadly t o

encompass a l l aspects of the administration of both

-rent asse ta and current l i a b i l i t i e s . 5

SCOPE AW IMPORTNICE Olr WORKING CAPITAL WAGEHENT

Working Capital Management i s an in tegra l part

of overa l l f inancia l management. It includes a number

of aspects t h a t makes it an important t op ic f o r study.

It attempts t o manage and control the current asse ts

and the current l i a b i l i t i e s i n order t o maximise

p ro f i t ab i l i t y and ensure proper l iquidi ty i n business.

That is why it has been r igh t ly said t h a t "Working

Capital Management has been looRed upon as the driving

s e a t of a Financial ~ a n a ~ e r ' . ~ It has a l so been

coneidere& as the l i f e blood an& controll ing nerve

centre of a business.' The manner of management of

5. Fred Weston, J, and Copeland Thanas, E., Mana e r i h l Finance, The Dryden Press, ~hfcago, 1986,?;;1$7T--

6. James C. Von Home, Financial Manaqement and Policy, q?.cit., p.384.

Working Capital t o a very large extent determines the

success of operations Of a concern. Constant Management

is required t o maintain appropriate levels i n the

Working Capital accounts. I t s importance i s seen from

the following factors:

Investment i n current a s se t s represents a sub-

s t a n t i a l portion of t o t a l investments. In some cases

it has been on an average three fourths of the t o t a l

assets. I n the cases of trading concerns they wen

account f o r about 83 per cent of the t o t a l investments. 8

Investments i n current a s se t s and the level of

current l i a b i l i t i e s have t o be geared quickly to changes

in Sales. To be sure, fixed assets investment and long

ten financing are a l so responsive t o var ia t ions i n

Sales. However, t h i s re la t ionship is not a s close and

d i r ec t a s it is i n the case of Working Capital Component. 9

It has a l so been faund t h a t the l a rges t portion of a f in -

ancia l Managers time is u t i l i s e d i n the Managanent of

Working Capital.

8. N.K. Agrawal, 9r.U. p.8.

9. Prasanna Chandhra - Financial Management - Theory and practice, Tata Mc Graw H i l l Publishing Company Ltd., New Delhi, 1984, p.259.

Character is t ica l ly , current a s s e t s represents

more than half t he t o t a l a s se t s of a business firm.

Slnce they represent such a l a rge investment ' this in-

vestment tends to be re l a t ive ly vo la t i l e , and hence

worthy of the f inancia l manager's careful attention.

Working Capital Management is pa r t i cu la r ly

important f o r small finn. Although such firm can mini-

mise t h e i r investments i n fixed a s se t s by rent ing o r

leas ing p lan t and equipment they cannot avoid investment

i n cash receivables and inventories. Working Capital

Management has acquired important posi t ion and g rea t

s ignif icance i n the recent past. I t i s ref lec ted by

t h e f a c t t h a t f inancia l Manager spends a great deal of

time i n managing current a s se t s and current l i a b i l i t i e s .

Arranging f o r Short Tenn financing,negotiating favourahle

terms of c red i t , control l ing the movement of cash, admi-

n i s t e r ing accounts receivable and monitoring the inves t -

ments i n inventories consume a great deal of time.

WORIUUG CAPITAL WAGEHENT AElb FIXJZD ASSETS MANAGEMEST

Management of f ixed a s se t s i s usual ly considered

t o f a l l within the realm of Capital budgeting, while

the administration of current a s se t s f a l l s within the

realm, Of Working Capital Management. The management

of current asse t s i s similar t o t h a t of fixed asse t s

i n the sense t h a t i n both the cases the firm analyses

t h e i r e f fec t s on its p r o f i t a b i l i t y and risk. However,

the management of fixed and current assets d i f f e r i n

three important ways: (a) i n managing fixed assets ,

time is very important; consequently: discounting and

canpounding aspects of time element play a s ignif icant

ro le i n cap i ta l budgeting and a minor one in the manage-

ment of current asse t s (b) Secondly, the large holdings

of current asse t s especial ly cash strengthens f inn ' s

l iqu id i ty (and reduce r i s k ) , but it a lso reduce the

overal l p rof i tab i l i ty . (c) Thirdly, the levels of

tixed a s well a s current asse t s depend upon the expected

sales, but it i s only the current asse t s which can be

adjusted with sa les f luctuat ions i n the short run.

PRINCIPLES OF WORKING CAPITAC MANAGEMENT

The f inancial manager of any concern should

consider the following principles while exercising

Working Capital Management:

PRINCIPLE OF RISK VARIATION

The word ' r i sk ' re fe rs t o the immobility of a

concern i n maintaining suf f ic ien t Working Capital t o

pay f o r its l i a b i l i t i e s . I f the Working Capital varies

r e l a t i v e t o sales, t h e leve l of r i s k t h a t a concern

assumes w i l l a l so vary, and the opportunity of loss o r

gain wi l l increase. I n otherwords, there is a dof in i te

relat ionship between t h e degree of r i sk and the ra te of

return. As a concern assumes more r isk, the opportunity

of gain o r l o s s increases accordingly. A s the level of

Working Capital re la t ive t o sa les decreases, the degree

of r i s k increases. Thus, i f the s i z e of the Working

Capital goes up, the amount of r i s k goes down and the

opportunity f o r loss/gain is likewise adversely affected.''

The s i z e of Working Capital depends upon the

a t t i t u d e of management. A conservative management l i k e s

t o reduce the r i s k by holding a higher level of Working

Capital, while a l i b e r a l management assumes higher and

higher r i s k by minimizing t h i s l w e l . The object of a

management should, howeveg, be t o maintain the level of

Working Capital which would optimize the concern's r a t e

of return.

2. PRINCIPLE OF COST OF CAPITAL

There a r e d i f f e r e n t sources of finance, and each

source has a d i f fe ren t cos t of Capital. It should be

kept i n mind t h a t t h e cos t of Capital is i n inverse

proportion t o risk. This means that , i f the cost of

10. Bardia, S.C., Working Capital Management - Pointer Publishers - Jaipur, 1988, p.4.

Capital is more-inplying more of Capital, the r e s u l t a n t

r i s k i s less . On t h e o ther hand i f the cos t i s l e s s

implying l e s s of Capital would lead t o more r isk.

Therefore while r a i s i n g finance, the finance manager

should i d e n t i f y a source which would minimise the r i s k

and maximise t h e return;

3. PRINCIPLE OF MATURITY OBLIGATICH

A firm should make every a t tanpt t o r e l a t e mat-

u r i t i n s of obligat ions t o i t s flow of i n t e r n a l l y created

funds. The f a i l u r e of such a match of generation t o

ou ts ide demand would accentuate the r isk.

4. PRINCIPLE OF EOUITY POSITION

The amount of Working Capital invested i n each

segment should be adequataly j u s t i f i e d by a concern's

equity posi t ion, t h a t i s every mpep invested in t h e

Working Capital contr ibute t o t h e n e t worth of t h e

concern. 11

CCNCEPT OF WORKING CAPITAL

Views d i f f e r on t h e concept and d e f i n i t i o n of

Working Capital. The f inanc ia l concept i s the 'gross'

concept. The 'gross Working Capital ' a l s o known a s

cur ren t Capital o r c i rucula t ing Capital is represented

11. Ibid. p.5.

by the sum t o t a l of a l l current asse ts of the enter-

prise. A s against t h i s , we have the accounting concept,

which i s a 'net concept'. The 'Net Working Capital'

i s the difference between current asse ts and current

l i a b i l i t i e s . These two concepts are not t o be regarded

a s mutually exclusive, Each has i t s relevance i n

speci f ic si tuations. 12

The gross concept is a going concern concept,

i n which management is par t icular ly interested because

f o r the productive u t i l i za t ion of f ixed asse ts a l l the

current a s se t s are necessary. Another aspect of the

gross Working Capital points t o the needs of arranging

funds t o finance current assets. Whenever a need f o r

Working Capital funds a r i se s due to tho increasing

level of business ac t iv i ty o r fo r any other reason,

the arrangement should be made quickly. Similarly, i f

some surplus funds a r i s e suddenly, they should not oe

allowed t o remain id l e , but should be invested i n short

t e n secur i t ies . In short the gross Working Capital is

the t o t a l of a l l current assets. Viz., cash, marketable

secur i t ies , accounts receivable and inventory. As against

t h i s , the n e t concept is useful t o guage the f inancia l

12. Ramamoorthy, V.E., S.S. p.6.

soundness of a firm and is of special i n t e r e s t t o sundry

credi tors and suppliers of short tenn loans and

This concept a l so covers the question of judicious mix

of long t e rn and shor t tenn funds fo r financing current

assets. According t o Lawrence 3. Gitman, "the Working

Capital is the proportion of a firms current assets

which a re financed fran long term funds.14

Both these concepts of Working capi ta i have t h e i r

own significance. "If the objective is t o measure the

s i ze and extent t o which currents assets are being used,

'gross concept' is useful where a s i n evaluating the

l i qu id i ty posit ion of an undertaking, 'net concept'

becomes pertinent and preferablen. 15

In summary, t he gross and the net Working Capital

concepts present two d i s t i n c t and important facets of

Working Capital management. There is no standard pres-

cr ip t ion se t t i ng out the precise amount of gross o r net

Working Capital, t ha t each enterprise needs. Each company

has i t s own constraints and plans giving r i s e t o indivi-

dual Working Capital problems and the available data

13. James C, Von Home - Finance Management and Po l i Prentice Hall of India (p) Ltd., New el hi, 1973fll p.384.

14. Gitman L.J., Principles of Manaqerial Finance - Harper and Row - New York 1976, p.150.

15. R a m a ~ ~ ~ ~ r t h y , V.E., %.&., p.7.

have t o be ident i f ied and analysed t o a ld proper

d e d s i o n s .I6

A f i m should maintain a sound Working Capital

posit ion. It should have adequate WorMng Capital t o

run its business operations. Both excessive a s -11

as inadequate Working Capital posit ions a re dangerous

f r an the firm's point of view. Excessive Working

Capital means i d l e funds which earn no prof i t . I n -

adequate Working Capital not only impairs the firms

p r o f i t a b i l i t y but a l so r e s u l t s i n production interrup-

t i ons and i n e f f i ~ i e n c i e s . ~ ~

DANGERS OF EXCESSIVE WORKING CAPITAL

The excessive Working Capital has the following

dangers I

1. It promotes unchecked accumulation u t iriverrtorie3,

gives room f o r inventory mishandling, waste, t h e f t

and losses.

2. It is an indication of permissive c r e d i t po l i c i e s

and s lack col lec t ion procedures, which may adver-

se ly a f f e c t the prof i t s .

16. nishra, R.K.. and Ravishanker, S., Current pers- pect ives i n Publicenterprises ManaqementL A j a n a Publications, New Delhi, 1985, p.316.

17. Pandey, I.X.. Pinancial Xanaq-nt Viluurh Publi- shing House (pvt.) Ltd., New el hi' 2, 1987, p.329.

3. Excessive Working Capital may develop .I f a l se

complacence which may ult imately degenerate i n t o

managerial i n ef f ic iencies . Impulsive decissions

on expansion may have t o be taken without examining

long term implications on p r o f i t s and growth.

4. Tendencies of accrrmulating inventories t o make

speculative p ro f i t8 grow . This may tend t o make dividend policy l i b e r a l and d i f f i c u l t t o cops with

i n fu tu re when t h e firm Is unable t o make specu-

l a t i v e prof i t&.

DANGERS OF IUADEQUATE WORKIUO CAPITAL

While the adequacy of the Working Capital i s a

v i r t u e the inadequacy is fraught with following dangers;.

1. It s tagnates growth. It beccmes d i f f i c u l t f o r

the firm t o undertake prof i table projects f o r

want of working Capital funds.

2. It becomes d i f f i c u l t t o implement operating plans

and achieve p r o f i t ta rget .

3. Operating ineffeciency creeps in when it becomes

d i f f i c u l t even t o meet day t o day commitments.

4. Fixed a s se t s a re not e f f i c i en t ly u t l l l zed fo r

t h e lack of Working Capital. Thus the r a t e of

re turn on investments slumps.

5. Paucity of Working Capital renders the f inn

unable t o avai l a t t r a c t i v e c red i t opportunities.

6. The firm loses i t s reputation when it is not i n

a posi t ion t o honour i ts comnitments. A s a

r e su l t , the firm faces t i g h t c r e d i t terms.

Financial managers should, therefore maintain

a r i g h t amount of Working Capital on a continuous

basis, only then a proper functioning of the businese

operations w i l l be ensured. Liquidity r a t i o s and

operating cycle period a r e the two important methods

of assessing t h e adequacy of Working Capital.

S.K. Bhattacharya and others have iden t i f i ed sane

r a t i o s t o judge the effectiveness of Working Capital

managementla and they a r e

1. P r o f i t after t a x a s percentage of Sales ( ~ ~ ~ / ~ a l d s )

2. Sales a s number of times t o t o t a l a s se t s (Sales/

Total asse ts) .

18. Bhattacharya, S.K., Raghavachari, M., and Singh,A.K., Determinants of e f f ec t ive Working Capital Management A Discriminant Analysis approach Uemographed, Indian I n s t i t u t e of Management Ahmedabad. ,

3. Ouick Assets an Percentages of Current L i a b i l i t i e s

(WCL).

4. Average receivables a s number of days Sales.

(AR/Mo. of days Sales)

5. I n t e r e s t paid a s percentage of p r o f i t before

i n t e r e s t and tax.

Another ind ica to r of t h e adequacy of Working

Capi ta l i s the operating cycle period of an enterprise.

Operating cycle can be determined on a stage-wise

basis. Af ter canputation of operating cycle period of

a concern, Working Capi ta l turnover r a t e can be calcul -

a ted and then t h e i r turnover r a t e can be used t o deter-

mine t h e Working Capita? requirements of an undertaking.

Placing t h i s along with t h e required amount of Working

Capi ta l w i l l give the excess amount locked up i n the

enterpr ise . The c a p a r i s o n o f - t h e norms suggested by

Tandon Comnittee r e l a t i n g t o maintanance of Working

Capital t o the ac tual8 obtained i n the undertakings

w i l l a l s o give a b e t t e r understanding of the excess o r

d e f i c i t Working Capital. For the smooth running of

any enterpr ise , adequate mount of Working Capital is

necessary and i n its abaence, t he f ixed a s s e t s cannot

be ga in fu l ly employed.

Apart from the above, thare is ye t another

method of estimating Working Capital. It is con-

ventional method. According t o the conventional

method, cash inflows and outflows are matched with

each other. More emphasis is la id down on l iquidi ty

and greater importance i s attached to current ratio,

l iqu id i ty r a t i o etc.. which pertain to the l iquidi ty

of an enterprise.

STRUCl'URE 'OF WORIUNO CAPITAL

Structure of Working Capital means the am-

Ponents of the Working Capital. The basic components

of the Working Capital a re current assets and current

l i a b i l i t i e s . The main elements of current assets are

cash and Bank Balances,receivables, inventories and

other quick resources l i k e short term investments.

Current l i a b i l i t i e s include payables, bank over draf ts ,

outstanding expenses proposed dividends, teuc payable

and incomes received i n advance.

The management of an enterprise should t r y

t o take maximrrm utiliscrtion of its canponenta a t the

minimum poesible cast. This is highly dependent on

t he s t r u c t u r e of Working capital . lP The following

a r e the important f ac to r s i n the analyr is of the

s t ruc tu re of Working Capital.

INVENTORY

Inventory general ly cons t i tu t e s a major portion

of cu r ren t asset.. The p r o f i t a b i l i t y of thm business

t o a l a r g e r extant depends upon the turnover 6f tho

Working Capi ta l and this i n turn depends upon the

turnover of t h e inventory. The term 'Inventory', means

the aggregate of those items of tengibla personal pro-

pe r ty which (1) a r e held f o r s a l e i n the ordinary

course of business, (2) are i n the process of production

of sa les , o r (3) a r e t o be current ly consumed i n pro-

duction of goods o r services to be avai lable f o r sale.

The i n v e n t o ~ y according t o the abwe def in i t i on

includes the following1 Raw materials, wrk-in-pr'ogrese

and f in ished goods.

RAW MATERIALS

Raw Materials means the items which a re held i n

t h e i r o r i g i n a l form, f o r processing and production.

I t is e s s e n t i a l t h a t the production should not suffer

19. Ja in , Ravi K., Workinq Capital Hanaqment of State Enternr ises i n India, National Publishing Honse, chaura Rasta, Jaipur, 1988, p.18.

' f o r want of stock. POr ensuring this, the purchase

of raw materials i n large quantities may minhise

purchasing overheads, increase the discounts,-at the

same time, excessive raw materials may lead t o incurring

higher carrying costs and wastages. Therefore t h i s

should be controlled by properly set t ing the m a x i m u m

and minimum levels of stocks, reordering level and

reorder quant i t ies etc.

WORK IN PROORESS

work i n progress inventory i s a camnon item i n

a l l the manufacturing concerns, because, no f i r n may

be able t o canpelete the manufacturing instantaneouely.

A t any phase of production, there w i l l be semifinished

goods o r work i n process. A t times the production

process w i l l be delayed so a s to sa t i s fy the part icular

choice, t a s t e and expected dwand of customers.

FINISHED GOODS

It is very important t o maintain a proper level

of finished goods i n a concern. Danger would be f e l t

on s i tua t ions of excess o r lower inventory. I f a firm

does not have enough etock of finished goods, it w i l l

not be i n a position to meet sudden demands of custaners.

I t may sometimes lose sales because the needed sto&

of finished goads may not immediately be available.

It may be economical t o hold a reasonable quantity of

finizhed goods. The f l ex ib i l i ty afforded by such an

inventory makes it possible f o r a firm t o meet sudden

o r unanticipated damand of custaners relatively a t

lower costs.

There a re tvo advantages of high level of

finished stocks They are (a) minimisation of loss of

sales and (b) minimisation of high additional costs

due t o many number of production operations. However,

the otheraide of the picture is, the high inventory

means high investments, which resul ts i n high carrying

costs (the main factor of which being interest) .. Therefore management should s t r ike a proper level of

finished goods inventory, keeping i n view the various

factors affecting it, The objective of the inventory

management would be the minimisation of id le cost of

men and machine caused by rhortage of raw materials,

s tores and spare parts and also t o keep low the inventory

ordering cost, (2) carrying cost, and the (3) investment

i n inventory and obsoleecence loSse.6..

In most of the business organisations, the

bulk of sa les would be on credit. This is probably

because of the f a c t tha t when l ibera l c red i t f a c i l i t i e s

are made available, the sa les would increase. I n t h i s

sense, receivables play aa important role i n emuring

a higher turnover f o r the firm cannmed. The practice

of carrying receivable* haa a few advantagrseuch as

(1) the reduction of collection costs over cash collsc-

tion, (2 ) reduction i n var iab i l i ty of saler , and

(3) increase i n the level of near term sales.

Credit and collection policies significantly

influence Working Capital requirements. When properly

formulated and executed, reduce the need of Working

Capital f o r operational purposes. Good credi t and

col lect ion pol icies aid in; sales promotion, so t h a t

the p r o f i t s b e m e more. Soundly conceived and exe-

cuted c red i t collection pol icies tend t o reduce the cost

of business. Finally, c red i t and collection pol icies

are necessary f o r the rnaintanance of good customer

relations.

Receivables const i tute a major canponant of

Working Capital, and a o it require the name type of

planning and control a s cash and inventories. The

volume of receivables outstanding a t any one time is

determined by an enterprise 's c red i t and collection

pol icies . The ro le of receivables i n the t o t a l f in-

ancial s t ruc ture depends on the enterprises c red i t

and col lect ion po l ic ies which i n turn i s very much

re la ted t o Working Capital.

CASH AND W K EIALAWCES

Cash is the most l iqu id asset t h a t a business

owns. It includes money and other i n a t m e n t s as

cheques, money orders o r bank dra f t s etc. Cash t o a

business is akin t o the blood f o r a human body. As

the blood imparts l i f e and strength, the cash imparts

p r o f i t s and solvency t o an enterprise.

A large bank balance reveals a sound l iquid

position. However from f inancial management's point

of view this pract ice is disapproved as it leads to

the holding of an asse t which is devoid not only of

earning power but i s on the contrary, expensive t o

retain." While the proportion of current assets held

20. Ibid. p.22.

i n the form of cash is very small, often between one

per cent and three per cent i t s effecient management

i s crucial t o the solvency of the business because in

a very important sense oash is the focal point of funda

flow i n a business.21 The objectives of cash management

a re t o make the most effect ive use of funds on the

one hand, t o accelerate the inflow and t o decelerate

the outflow of cash on the other hand.

It has become a pract ice with the modern

business organisations t o invest a par t of the i r ear-

nings i n asse t s which a re eas i ly convertible in to cash

(Marketable Securities) t o avoid too much redundant

cash. Sdch assets may be Government Securities, bonds

debentures and shares t h a t a re readily saleable without

loss of value.

CURRENT LIABILITIES

Current assets are not the only factor which

count i n designing the s t ructure of Wcrking Capital.

There is the l i a b i l i t i e s s ide also, such a s trade

credi tors , b i l l s payable, bank overdrafts, tax payables,

-- -

21. Prasanna Chandhra, &.&., p.277.

proposed dividends, outstanding expenses etc. Taxes

and proposed dividends have major influence on the

Working Capital s t ruc ture of a bwiness. Corporate

incane t a x reduces the ne t earnings of an enterprise.

However, the management does not usually have a high

degree of f l e x i b i l i t y i n these matters and hance the

focus of the management is therefore limited to

handling of current assets . 22

DETJSWINWTS OF WOIU(IPIQ CAPITAL

There a re no s e t rules o r formulae t o deter-

mine the Working Capital requirements of the firms.

A l a rge number of fac tors influence the Working

Capital needs of the firm. A l l the factors are of

d i f f e r e n t importance. Also, the importance of those

fac tors change frcnn firm t o firm and a l so f o r a firm

over time. Those fac tors are: (1) Nature and Size

of business, (2) Manufacturing cycle ( 3 ) Business

f luctuat ions (4) P r d u c t i o n policy (5) Firms c r e d i t

policy ( 6 ) Availabi l i ty of c r e d i t ( 7 ) Growth and

expansion a c t i v i t i e s (8) P r o f i t margin and p r o f i t

appropriation ( 9 ) Price leve l changes and l a s t l y

(10) Operating efficiency. Depending upon the

app l icab i l i ty of these concepts t o the f i rn , the

canposition and quantity of Working Capital -may

vary from firm t o firm.

OPTIMUM LEVEL OF CURRENT ASSETS

The f inancial manager ahould deternine the

0 9 t h ~ l eve l of current asse t s so t h a t the wealth

of the share holders be maximised. I n fact , optimum

leve l for each typo of current asaeta mhould ba

fixed.

CURRENT ASSETS AND FIXED ASSETS

A firm needs fixed and current asse t s to

support a par t i cu la r l eve l of output. However, t o

support the same leve l of output, the firms may have

d i f f e r e n t l eve l s of current assets. As the firm's

output and sa les increases, the need f o r current

asse t s a l s o increases, but not i n d i r e c t proportion

t o output, it increases a t a decreasing rate , because

of the economies of l a rge scale operations.

The leve l of Current asse t s can be measured

by r e l a t i n g it t o fixed assets. Assuming a constant

l eve l of fixed assets, a higher current asset/fixed

asse t s r a t i o indicates a consemative current asseta

policy and a lover Current asse+s/Mxed wae t . means

an aggressive current asset. policy. Other things

remaining constant, conservative policy implies

g rea te r l iqu id i ty and lower risk: While an aggre-

ss ive policy indicate a higher r i s k and poor

liquidity.23 The current assets policy of the moat

firms mby f a l l between these two extremes.

The firm would make j u s t enough investments

i n currents assets, i f it were possible t o estimato

working cap i ta l needs exactly. Under perfect cer-

taibnty, the current asse t s holdings would be a t the

minimum level. A large investments i n current assets

would mean a low r a t e of return on investment, a

smaller investments i n current assets, on the other

hand, would mean interruption i n production and

sales, because of frequent stock outs, Md inab i l i ty

t o pay f o r credi tors i n time.

23. Pandey, I.M., Financial Management, Vikas Publi- House, Pvt. Ltd., New Delhi 2, 1987, p.336.

However, as it is not possible t o estimate

working c a p i t a l needs accurately, the firm muat

decide about the l eve l s of current asse t s to bo

carried. The current asset8 holding of the f i m

w i l l depend upon i t s worklng cap i ta l policy. It

may follow a conservative o r an aggressive policy.

These po l ic ies have d i f f e r e n t rirk-return implica-

tions. A conservative policy means lower returns

and r i sk , while an aggressive policy leads to higher

return and higher r isk.

Apart from the, working cap i ta l policy leading

t o risk-return tangle, a firm may face two important

but conf l ic t ing a i m s of Working cap i ta l management,

namely p r o f i t a b i l i t y and solvency. Solvency re fe rs

t o the f i m s continuous a b i l i t y to meet maturing

obligations. To ensure solvency, the firm should be ,

very l iquid, tying up of current asseta in i d l e in -

vestments increasing cost and decreasing prof i t ab i l i ty .

TO have higher p r o f i t a b i l i t y , the firm may have to

s a c r i f i c e solvency and maintain a re la t ive ly low leve l

of current assets. Its p r o f i t a b i l i t y may bupmve as

l e s s funds are t i e d up i n i d l e current asseta, but

solvency would be threatened a8 a consequence t o it.

In determining the optimum l w e l of current assets,

the firm should balance the prof i tabi l i ty solvency tangle

by minimising the t o t a l cost (cost of l iquidi ty and cost

i l l i qu id i ty ) . Pig.III.1 COST TRADE 01F '

'-----..---' Level of current assets Optimum level of

{ U

current asse ts

Total Cost

Cost of Liquidity Minimum y , I I

I Cost of I l l iquidi ty I I

Sources I.M. Pondey m.Cit., p.338.

That level of current asse ts where the a m of these two

cost i s minimum i s the optimum level of current assets.

TYPES OF WORKING CAPITAL

The working capi ta l tha t a firm would require

may ba broadly divided in to two namely permanent,

f ixed o r regular bwrklng capi ta l and tearporaq,

fluctuating/Parfable o r seasonal workinp capital.

~enahnent working capi ta l is that level of curmnt assets

which is continuously required by the firm t o carty on i t s

business operations without any interruptions. Teporary/

variable working capi ta l i s t ha t level of current assets

which are required over and above the permanent working

capital ,24 depending on the changes i n production and sa les

levels. Both, the types of working capi ta l are necessary

t o f a c i l i t a t e production and sales through operating cycle.

Some times it i s c lass i f ied in to three viz., penanent,

temporary and seasonal. These clbssifications of working

capi ta l concept i s necessary f o r the purpose of taking

financing decisions.

7 Fig.III.2 PE- MTD T- WORKIW; CAPITAL

Permanent working capita:

Source: BARDIA, S.C., Working -pita1 Nanagaaent,p.l3.

24. Joy, D.H., Introduction t o Financial Management, House vood J l l i no r s ~ i c h a r d , D., Irwin 1977, p.407.

The permanent working capi ta l i s stable over

tima, while t e p o r a r y wrking capi ta l i s f luctuating

scmetimss i n c m ~ i n g and some other times decreasing.

a s i n Pig. 111.2. Hovsver f o r a growing firm, the

permanent working cap i t a l may not be stable, it would

a l so be increasing a s it grows and therefore the

permanent working cap i t a l l i n e w i l l not be horieontal

s t r a igh t l i n e as i n the previous case. It w i l l be

gradually r i s ing a s i s shown i n Pig. 111.3.

Pig.III.3. PERHWEM' AND TEUPORARY WORKING CAPITAC OF QROWING COMPAElY

Temporary o r Fluctuating Working Capital

- Y Permanent Working -- Capital 1 +

0 T lrne

Source: Bardia, S.C., Working Capital Management, p.14.

Ogtfmrm! l eve l of working cap i ta l has been

emphasised because both excessive as well as bade-

quate working cap i ta l positions are-dangerous ftom

the firm's point of view. While excessive vorking

cap i ta l means i d l e funds vhich earn no prof i t s f o r

the firm, paucity of working capi tal not only impairs

f i rni3profi tabi l i ty but a l so m s u l t s i n production

interrppt lons and inefficiencies.

FmWCMG OF WORKING CAPITAL

The financial manager should determine the

optimum leve l of working cap i ta l (Gross) so t h a t

t h e wealth of the share holders be rnaxtmisad. The

f i n a needs fixed and current assets t o support a

par t i cu la r l eve l of output. However, t o Bugport the

same leve l of output, the firm can have different

l eve l s of current assets. The current assets of a

firm may be financed by e i t h e r long term o r short

term and o r spontanaous sources of financing. The

inportant long te rn sources of finance are shares,

debenture, preference shares retained earnings and

debts f ram f inancia1 inst i tut ions. Short term source8

of finance a r e shor t term cred i t (~ank lo-, corrmer-

c ia1 papers and factoring receivables). Spontaneour,

financing re fe rs to the aukmatic sources of short

t e r n funda l i k e t rade c red i t s and outatanding ex-

penses. hey a r e cos t free. Thus, the real choice

of financing current peseta is In between short

term and long term sources. Even assuming t h a t the

l eve l of spontaneous current l i a b i l i t i e s is deter-

mined by extraneous fac tors ( l i k e business practice,

incoma tax and dividend pol icies etc.) the important

question i n gross working capital/currant asaeta

financing l e t What should be the re la t ive proportion

of shor t t e r n and long term aouroa of finance. To

f ind out a solut ion f o r the above question, the

following th ree approaches a re resorted t o by the

finance managers.

The d i f f e r e n t approaches f o r financing the

current asse t s are: (1) matching approach, (2 ) conaer-

vat ive approach and (3) aggressive approach.

A firm can adopt a f inancial plan which

involves the matching of the expected l i f e of the

a s s e t s with the expected l i f e of the source of funds

raised t o finance it. Thus a ten year loan may be

raised t o finance a plant w i t h an a x p e c t d l i f e of

ten years; Stock to be sold i n t h r i t y days may be

financed with a t h i r t y days bank loan and #o on.

The j u s t i f i c a t i o n f o r the -act matching is that,

s ince Me purpose of financing i m to pay f o r tha

assets , the financing should be relinquished when

the a s s e t is expected t o be relinquished. Using

long term finance f o r short terra asse t is expensive

as the funds w i l l not be u t i l i r e d f o r the f u l l period.

Similarly, financing long term assets with short

term finance is cost ly a s well as inconvenient an

arrangements f o r the new short tenn-finance w i l l

have to be made an a continuing basis. Thus, when

the firm follows matching approach (also known as

hedging approach), long term finances w i l l 'be used

to finance fixed asse t s and permanent current assets

and s h o r t term source t o finance temproary o r variable

current assets. However, the exact matching is not

possible because of uncertainty about the expected

l i v e s of assets. This is shown i n Fig.III.4.

Pig.III.4 FINANCING UUDER HATCHING PLAN

X Temperory cur ren t r

a s s e t s Short Term Financing

Permanent cur ren t a s s e t s Long Term Financing

__C____

Fixed a s s e t s

i Time

Sources Pandey, I.M., Financial Management, p. 341.

The f i n ' s f ixed a s s e t s and permanent cur ren t a s s e t s

a r e f inanced with long term funds and as the l w e l of

these a s s e t s increases, t h e long t e n f inancing leve l

a l s o increases. The temporary o r var iab le current

a s s e t s a r e financed with s h o r t term funds and a s t h e i r

l e v e l increases, the l e v e l of s h o r t term financing a l s o

increases.

An exact matching plan may not be possible

t o be adopted i n practice. A firm may adopt a

conservative approach i n financing i t s current and

f ixed assets. The financing policy of the f inn ir,

sa id t o be conservative vhen it depends mom on

long term f ~ m l S f o r i t s financing needs. i.e..

the firm may finance its permanent current asse t s

and a p a r t of temporary current asse t s with long

term finances. !ITIus, i n periods when the tinn has

no temporary current assets , it s tores l iqu id i ty by

invest ing surplus funds i n t o marketable securi t ies .

The conservative plan r e l i e s heavily on long term

financing, and therefore, i s l e s s risky.

AGGRESSIVE APPROAQ1

A firm may sa id t o be aggressive i n financing

i ts a s s e t s *en it uses more of short term finance

than warrented by the matching plan. Under an aggre-

s s ive policy, the firm finances a p a r t of i t s per-

manent current a s s e t s a l so with short term financing.

Sane extremely aggressive firms may even finance a

p a r t of t h e i r fixed asse t s with short term financing.

The r e l a t i v e l y more use of short t e rn finance makes

the firm more risky. This is i l lustrated.with the

help of the following Figure.

FIG 111.5 AORESSWE FINANCIMO

*n L 'n VI

FIXED ASSETS

short Term h d a

Long Term ' Funds

Sources Pandey I.M. Financial Managamant OJ.C&., p.343

TEQWIQUES OF WORKXUG CAPITAL ANALYSIS

A Study of the causes of changes t h a t take

place i n the working capi ta l balances from time t o

time is necessary.25 The objectives of euch an analysia

is t o f i n d out whether the management i s u t i l f s ing

the working cap i t a l ef fec t ively o r not,-, o r t o

find out whether the amount of vorking capi ta l

25. M.H.B. and E.S., Motaal: "Working Capital i t s role i n the short run l iqu id i ty Policy of Indus tda l concern* Accountins Research Vo1.9, 2988, p.266.

is adequate, excess o r inadequate. It may also be

t o f ind out whether the f ino in question i s i n a

posi t ion t o pay i t s shor t term debts pmmtly o r not

and f i n a l l y it may f ind ou t the source of working

capi tal .

There a r e so many techniques t o analyae th.

working c a p i t a l of an enterprise. Among them, the

most frequently w e d a m (1) Ratio analysia (2) Iunda

flow analysis, (3) trend analysis and (4) Cost wlune

p r o f i t analysis etc.

RATIO ANALYSIS

Ratios a r e simply a means of highlighting i n

ar i thmatical terms the relat ionship between figures

drawn from f inanc ia l statements.26 Ratio analysis

takes two forms: (1) behaviour of ra t ios w a r a period

of years t o determine trend, (2) comparing- ra t ios of

one concern with those of other concern i n the same

l i n e of business. This can be used by management as

a technique of analysis t o judge the efficiency with

which working cap i ta l is being used i n an enterprise.

26. Pearson Hunt and William Donaldson, Basic businesr finance t e x t and cases, Richard D., Irwin House Homewood, I l l h o i e , 1966, p.141.

The Important r a t i o s t h a t can be used f o r

management of w r k i a g c a p i t a l are: (1) turnover of

working c a p i t a l (net aales/net working cap i ta l )

(2) cur ren t r a t i o (3) current debt t o tangible ne t

worth r a t i o (current hiabi l i t ies / tangible net worth).

Although r a t i o analysis is used widely, it

should be kept i n mind t h a t "no one r a t i o w i l l give

t h e e n t i r e picture, but they do tend t o give indi-

c a t i o n ~ , which cumulatively aas ie t considerably i n

appraisal of f inanc ia l posi t ions and operations of

the organisation. 27

This analysis is an e f fec t ive management tool

t o study how funds have been procured f o r the business

and how they have been employed. This technique helps

to analyse changes i n working cap i ta l components bet-

ween two dates.

27. Herald Bierman, Financial Accountin the?=, Tho k c Millan Compapy, Hew York, 1st Giti;:-, p.255.

f n Spite of its We for owners and creditor8

in f inancial deciaion making, it does not c l d f y

the importance of movements i n the working capital

structure. Ruther , this technique can be used only

by the internal managanent i n i ts control of working

capi tal and does not throw l i g h t on the quertions

whether the cap i ta . is being wed most affbciently

o r whether the current financial position of the firm

h a improved o r not.

Trend analysis make. it easy to underatand

the changes i n an item o r a group of iteas w e r a

period of time and to draw conclwions regarding the

changes i n data. For t h i s analysis, a baae year is

chosen and the amount of t h a t item relat ing t o the

base year i s taken equal t o 100 and i n d w numbers

are calculated f o r the other years bared on the amount8

of t h a t item In those years. This i a a dynamic method

of analysis showing the changes over a period of t h e .

Since it indicates the direction i n which a

finn is going, W e analysis may be useful i f the

analyst wants to study the changes over a long period

of time, it may be applied i f a t a11 the period of

etudy i n not learn than 5 yearn, so that it may ba of

help i n forecasting the future trends.

COST VOLUME PROPIT MALYSIS

Under t h i s method cash break even chart is

prepared with t h e p u p s 8 of showing cash rewrements.

Certain items may have to be paid f o r i n cssh while

others not. Credit may have been allowed to customer.

f o r goods and services eold or granted t o the enterprire

f o r materialssupplied t o it during a part icular period,

and t h e cash break even chart shows only the actual

payments and not the expenses incurria.

A break even point is also the most important

technique f o r analysing the working capital.. The cost

volume p r o f i t analysis deals with the net e f fec t of

changes i n cost, p r ice and volume on profi ts . It not

only helps the management i n p r o f i t projection but

a l so i s very useful i n v i r tua l ly a l l decision making

5una other trchnipuor l ike cash flow analysis

and a f e w mtati~tical-mathamatical techniques l i k e

index number, range, correlation and repression

analysis a re a l so used i n this.

CoNausIca

The management of current assets and current

l i a b i l i t i e s and the i n t e r relationship that axists

between them may be termed as working capi tal mana-

gement. It involve the administration of short term

asse t s l ike, cash Marketable securi t ies accounts

receivable and inventories on the one s ide and the

current l i a b i l i t i e s on the other and tha t is why techni-

ca l ly it is considered a s an integral par t of financial

management.

Because of i t s impartance i n corporate sector,

it has been considered as the l i f e blood and controlling

nerve centre of business and also looked upon as the

driving 'seat of a financial manager.

A firm requires both the fixed assets and

current assets, however the effect ive u t i l i sa t ion of

the fixed asse t s depends upon the amount and usage of

the current assets. A financial manager has t o consider

the principles of r i sk variation, cost of capita1,maturity

obligations and equity positions in exercising vorkiag

capi tal managenant. These principler may help to undo$-

stand t h a t adequacy i s a vir tue surplus is not. TO

ident i fy the adequate amount of working capital and

effect ive u t i l i r a t i o n of it the finanm manager can

also use same of the accounting rat ios as well.

The analysis of working capital structure may

help t o take m a x i m uti l izat ion of i t s canponentr a t

the minimum possible cost. This may also help t o locate

the r igh t proportion of the components like, Inventory,

Sundry Debtors, accounts receivable, and cash and Bank

balances. The determinants of the Working Capital struc-

ture are the nature and s ize of business, manufacturing

cycle, business fluctuations, production policy, f i n s

c red i t policy, avai labi l i ty of credit, gruwth and expans-

ion ac t iv i t i es , p rof i t margin and price level changes.

While detennining the optimum level of current

assets, the financial manager may be entangled i n the

l iquidi ty Vs. p rof i t ab i l i ty and r isk Vs. return tangles.

While l iqu id i ty may reduce the risk, it lacks profita-

b i l i t y the profitable use of the current assets may

lack l i q u i d i t y and i n the same way when he invests

the current asse t s i n a high incaw earning invent-

ments, it increases the r isk, while t rying t o raduco

the r isk, he may ge t a decreased return. merefore

while determining the optimum level of current assets,

the firm should balance the prof i t ab i l i ty solvancy

tangle by minimising the t o t a l cost by maintaining

i t s current asse t s a t t h a t l eve l where the sm of

the t h e cos t of l iqu id i ty and i l l i q u i d i t y i s minimmn.

Fi9.111.1.

For any firm, both the permanenr and temp-

rorary forms of working cap i ta l a r e necessary t o

f a c i l i t a t e production and sa les through operating

cycle. The quantum and s i z e of permanant and temp-

orary forms of working cap i ta l may d i f f e r ran firm

t o firm and a l s o fmm time t o t h e depending upon the

nature of business and leve l s of act ivi ty . Depending

upon the requirements, the r igh t sources have t o ba

tapped t o minimise the costs and r i sks and o p t M s e

the l i q u i d i t y and prof i t ab i l i ty . Eventhough there

are conservative, aggressive and matching approaches

of financing of working capi tal , t o guide, the matching

concept alone may help achieve the goals of finmcing.

There u e many tachniques of working

c a p i t a l analysia and out of them, the r a t i o analysis,

fund and cash flow analysis, trend analyeis are more

popular. O+ourse the analysis l i k e correlation,

regression, time s e r i e s and c o s t mime p r o f i t

analysis a r e a l s o used. But however the fonner

group may be f o r t h e aggregate use while the l a t t e r

may have appropriate use while deciding t h e indivi-

dual item of the current assets.