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Working Capital Management

Working Capital Management (WCM)
Definition 1:
Working capital management involves the relationship between a firm's short-term
assets and its short-term liabilities. The goal of working capital management is to
ensure that a firm is able to continue its operations and that it has sufficient ability to
satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts receivable and
payable, and cash.
Definition 2:
The term ‘working capital management’ primarily refers to the efforts of the
management towards effective management of current assets and current liabilities.
Working capital is nothing but the difference between the current assets and current
liabilities. In other words, an efficient working capital management means ensuring
sufficient liquidity in the business to be able to satisfy short-term expenses and debts.
In a broader view, ‘working capital management’ includes working capital
financing apart from managing the current assets and liabilities. That adds the
responsibility for arranging the working capital at the lowest possible cost and utilizing
the capital cost-effectively.
Definition 3:
Decisions relating to working capital and short-term financing are referred to as working
capital management. These involve managing the relationship between a firm's shortterm assets and its short-term liabilities. The goal of working capital management is to
ensure that the firm is able to continue its operations and that it has sufficient cash flow
to satisfy both maturing short-term debt and upcoming operational expenses.
A managerial accounting strategy focusing on maintaining efficient levels of both components of
working capital, current assets, and current liabilities, in respect to each other. Working capital
management ensures a company has sufficient cash flow in order to meet its short-term debt
obligations and operating expenses.
Breaking Down Working Capital Management
Working capital management commonly involves monitoring cash flow, assets, and
liabilities through the ratio analysis of key elements of operating expenses, including the
working capital ratio, collection ratio, and the inventory turnover ratio. Efficient working
capital management helps maintain the smooth operation of the operating cycle (the
minimum amount of time required to convert net current assets and liabilities into cash)
and can also help to improve the company's earnings and profitability. Management of
working capital includes inventory management and management of accounts
receivables and accounts payables. The main objectives of working capital
management include maintaining the working capital operating cycle and ensuring its
ordered operation, minimizing the cost of capital spent on the working capital, and
maximizing the return on current asset investments.
Objectives of Working Capital Management
The primary objectives of working capital management include the following:
Smooth Operating Cycle: The key objective of working capital management is
to ensure a smooth operating cycle. It means the cycle should never stop for the
lack of liquidity whether it is for buying raw material, salaries, tax payments etc.
Lowest Working Capital: For achieving the smooth operating cycle, it is also
important to keep the requirement of working capital at the lowest. This may be
achieved by favorable credit terms with accounts payable and receivables both,
faster production cycle, effective inventory management etc.
Minimize Rate of Interest or Cost of Capital: It is important to understand that
the interest cost of capital is one of the major costs in any firm. The management
of the firm should negotiate well with the financial institutions, select the right
mode of finance, maintain optimal capital structure etc.
Optimal Return on Current Asset Investment: In many businesses, you have
a liquidity crunch at one point of time and excess liquidity at another. This
happens mostly with seasonal industries. At the time of excess liquidity, the
management should have good short-term investment avenues to take benefit of
the idle funds.
Advantages of Working Capital Management
Working capital management ensures sufficient liquidity when required.
It evades interruptions in operations.
Profitability maximized.
Achieves better financial health.
Develops competitive advantage due to streamlined operations.
Disadvantages of Working Capital Management
It only considers monetary factors. There are non-monetary factors that it ignores
like customer and employee satisfaction, government policy, market trend etc.
Difficult to accommodate sudden economic changes.
Too high dependence on data is another downside. A smaller organization may
not have such data generation.
Too many variables to keep in mind say current ratios, quick ratios, collection
periods, etc.
Importance of Effective Working Capital
Although the importance of working capital is unquestionable in any type of business.
Working capital management is a day to day activity, unlike capital budgeting decisions.
Most importantly, inefficiencies at any levels of management have an impact on the
working capital and its management. Following are the main points that signify why it is
important to take the management of working capital seriously.
Ensures Higher Return on Capital
Improvement in Credit Profile &
Increased Profitability
Better Liquidity
Business Value Appreciation
Most Suitable Financing Terms
Interruption Free Production
Readiness for Shocks and Peak
Advantage over Competitors
Elements of Working Capital Management
The working capital ratio, calculated as current assets divided by current liabilities, is
considered a key indicator of a company's fundamental financial health since it indicates
the company's ability to successfully meet all of its short-term financial obligations.
Although numbers vary by industry, a working capital ratio below 1.0 is generally
indicative of a company having trouble meeting its short-term obligations. Working
capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may
indicate a company is not effectively using its assets to increase revenues.
The collection ratio, also known as the average collection period ratio, is a principal
measure of how efficiently a company manages its accounts receivables. The collection
ratio is calculated as the product of the number of days in an accounting
period multiplied by the average amount of outstanding accounts receivables divided by
the total amount of net credit sales during the accounting period. The collection ratio
calculation provides the average number of days it takes a company to receive
payment. The lower a company's collection ratio, the more efficient its cash flow.
The final element of working capital management is inventory management. To operate
with maximum efficiency and maintain a comfortably high level of working capital, a
company must carefully balance sufficient inventory on hand to meet customers' needs
while avoiding unnecessary inventory that ties up working capital for a long period
before it is converted into cash. Companies typically measure how efficiently that
balance is maintained by monitoring the inventory turnover ratio. The inventory turnover
ratio, calculated as revenues divided by inventory cost, reveals how rapidly a company's
inventory is being sold and replenished. A relatively low ratio compared to industry
peers indicates inventory levels are excessively high, while a relatively high ratio
indicates the efficiency of inventory ordering can be improved.
Decisions in Working Capital Management
If anybody describes the benefits of working capital management in terms of money, it
would most likely be the cost of capital that a business pays on the investment in
working capital. The amount of this cost would depend on two things viz. the quantum of
working capital required and the cost of working capital. The quantum of working capital
is decided by the working capital policies of a company whereas the optimization of the
cost of capital is worked out with working capital management strategies.
Working Capital Deciding Factors – Level and
Mode of Financing
The two main factors that decide the quantum of working capital that a business should
maintain, are liquidity and profitability. Let’s understand the impact of both of these
factors in details.
Nobody denies the importance of liquidity, but most have a question that how much that
liquidity should be? What are the right levels of liquidity? We know that a business can’t
sit on unlimited or too high liquidity because higher liquidity means higher investment in
working capital. And higher investment in working capital means higher cost of capital,
interest cost in case financed by bank finance. Therefore, the higher liquidity has a
direct impact on the profitability as the capital cost rises. In essence, the relation
between liquidity and profitability is inverse. On one hand, higher rather sufficient
liquidity is the primary goal of working capital management. Whereas on the other hand,
profitability as an objective aligns with the overall objective of an organization i.e. wealth
With that, it is quite clear that a policy that an organization follows would fall between
these pillars. There may be policies that are tilted towards liquidity and others may be
towards profitability. It is then a management decision where do they want to place
their organization’s policy.
Working Capital Management Policies
Working capital management policies deal with the quantum factor i.e. how much of
current assets should be maintained? These policies, in essence, are different levels of
the tradeoff between liquidity and profitability. Theoretically, following three types of
policies are explained whereas they can be n number of policies depending on where
the tradeoff is stricken between the liquidity and profitability.
Relaxed Policy / Conservative policy – This policy has a high level of current
assets maintained to honor the current liabilities. Here, the liquidity is very high
and the direct impact on profitability is also high.
Restricted Policy / Aggressive policy – This policy a lower level of current
assets. Here, the liquidity levels are very low, therefore, the direct impact on
profitability is also low.
Moderate Policy – It lies between the conservative and aggressive policy.
Working Capital Management Strategies
Working capital management strategies deal with the cost of capital factor. The question
is – How the costs of capital are optimized? A business has a choice to select between
short-term vs. long-term sources of capital. Normally, the short-term funds are cheaper
to long-term but risky. Short term funds are risky in terms of risk of refinancing and risk
of rising interest rates. Once they mature, they may not be refinanced by the same
financial institution and there is a possibility of revision in interest rate every time they
are renewed.
Let’s divide a firm’s capital investment into two i.e. investment in fixed assets and
investment in working capital. Let’s safely assume that long-term funds finance the fixed
assets. Now remaining is working capital. Let us further divide working capital into two
i.e. permanent and temporary working capital. The nature of permanent working capital
is similar to fixed assets i.e. that level of investment in working is always present and
remaining part keeps fluctuating. The working capital management strategies define
how these two types of working capital are financed.
Hedging (Maturity Matching) Strategy – This strategy follows the principal of
finance i.e. long-term funds to finance long-term assets and vice versa. In this
strategy, the maturities of currents are matched with the maturity of its financing
instrument. It does not have any cushion or flexibility in case of any delay in the
realization of current assets. Although it is a very ideal strategy but involves a
high risk of bankruptcy.
Conservative – It’s a safer strategy where the apart from financing the whole of
the permanent working capital, it finances a part of temporary working capital
Aggressive – It’s a high-risk strategy where the apart from financing the whole of
the temporary working capital, it finances a part of permanent working capital
Decision criteria
By definition, working capital management entails short-term decisions—generally,
relating to the next one-year period—which are "reversible". These decisions are
therefore not taken on the same basis as capital-investment decisions (NPV or related,
as above); rather, they will be based on cash flows, or profitability, or both.
One measure of cash flow is provided by the cash conversion cycle—the net number
of days from the outlay of cash for raw material to receiving payment from the customer.
As a management tool, this metric makes explicit the inter-relatedness of decisions
relating to inventories, accounts receivable and payable, and cash. Because this
number effectively corresponds to the time that the firm's cash is tied up in operations
and unavailable for other activities, management generally aims at a low net count.
In this context, the most useful measure of profitability is return on capital (ROC). The
result is shown as a percentage, determined by dividing relevant income for the 12
months by capital employed; return on equity (ROE) shows this result for the firm's
shareholders. Firm value is enhanced when, and if, the return on capital, which results
from working-capital management, exceeds the cost of capital, which results from
capital investment decisions as above. ROC measures are therefore useful as a
management tool, in that they link short-term policy with long-term decision making.
Credit policy of the firm: Another factor affecting working capital management is credit
policy of the firm. It includes buying of raw material and selling of finished goods either
in cash or on credit. This affects the cash conversion cycle.
Management of Working Capital
Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital. The policies aim at managing
the current assets (generally cash and cash equivalents, inventories and debtors) and
the short-term financing, such that cash flows and returns are acceptable.
Cash management. Identify the cash balance which allows for the business to meet
day to day expenses, but reduces cash holding costs.
Inventory management. Identify the level of inventory which allows for
uninterrupted production but reduces the investment in raw materials—and
minimizes reordering costs—and hence increases cash flow. Besides this, the lead
times in production should be lowered to reduce Work in Process (WIP) and
similarly, the Finished Goods should be kept on as low level as possible to avoid
Debtors management. Identify the appropriate credit policy, i.e. credit terms which
will attract customers, such that any impact on cash flows and the cash conversion
cycle will be offset by increased revenue and hence Return on Capital (or vice
Short-term financing. Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;
however, it may be necessary to utilize a bank loan (or overdraft), or to "convert
debtors to cash" through "factoring".
Why Firms Hold Cash
The finance profession recognizes the three primary reasons offered by economist John
Maynard Keynes to explain why firms hold cash. The three reasons are for the purpose
of speculation, for the purpose of precaution, and for the purpose of making
transactions. All three of these reasons stem from the need for companies to possess
Speculation - Economist Keynes described this reason for holding cash as
creating the ability for a firm to take advantage of special opportunities that if
acted upon quickly will favor the firm. An example of this would be purchasing
extra inventory at a discount that is greater than the carrying costs of holding the
Precaution - Holding cash as a precaution serves as an emergency fund for a
firm. If expected cash inflows are not received as expected cash held on a
precautionary basis could be used to satisfy short-term obligations that the cash
inflow may have been bench marked for.
Transaction - Firms are in existence to create products or provide services. The
providing of services and creating of products results in the need for cash inflows
and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow
needs that they have.
Float is defined as the difference between the book balance and the bank balance of an
account. For example, assume that you go to the bank and open a checking account
with $500. You receive no interest on the $500 and pay no fee to have the account.
Now assume that you receive your water bill in the mail and that it is for $100. You write
a check for $100 and mail it to the water company. At the time you write the $100 check
you also record the payment in your bank register. Your bank register reflects the book
value of the checking account. The check will literally be "in the mail" for a few days
before it is received by the water company and may go several more days before the
water company cashes it.
The time between the moment you write the check and the time the bank cashes the
check there is a difference in your book balance and the balance the bank lists for your
checking account. That difference is float. This float can be managed. If you know that
the bank will not learn about your check for five days, you could take the $100 and
invest it in a savings account at the bank for the five days and then place it back into
your checking account "just in time" to cover the $100 check.
Book Balance
Time 0 (make deposit)
Time 1 (write $100 check)
Time 2 (bank receives check)
Bank Balance
Float is calculated by subtracting the book balance from the bank balance.
Float at Time 0: $500 − $500 = $0
Float at Time 1: $500 − $400 = $100
Float at Time 2: $400 − $400 = $0
Ways to Manage Cash
Firms can manage cash in virtually all areas of operations that involve the use of cash. The goal is to
receive cash as soon as possible while at the same time waiting to pay out cash as long as possible.
Below are several examples of how firms are able to do this.
Policy for Cash Being Held
Here a firm already is holding the cash, so the goal is to maximize the benefits from
holding it and wait to pay out the cash being held until the last possible moment.
Previously there was a discussion on Float which includes an example based on a
checking account. That example is expanded here.
Assume that rather than investing $500 in a checking account that does not pay any
interest, you invest that $500 in liquid investments. Further assume that the bank
believes you to be a low credit risk and allows you to maintain a balance of $0 in your
checking account.
This allows you to write a $100 check to the water company and then transfer funds
from your investment to the checking account in a "just in time" (JIT) fashion. By
employing this JIT system, you are able to draw interest on the entire $500 up until you
need the $100 to pay the water company. Firms often have policies similar to this one to
allow them to maximize idle cash.
The goal for cash management here is to shorten the amount of time before the cash is
received. Firms that make sales on credit are able to decrease the amount of time that
their customers wait until they pay the firm by offering discounts.
For example, credit sales are often made with terms such as 3/10 net 60. The first part
of the sales term "3/10" means that if the customer pays for the sale within 10 days they
will receive a 3% discount on the sale. The remainder of the sales term, "net 60," means
that the bill is due within 60 days. By offering an inducement, the 3% discount in this
case, firms are able to cause their customers to pay off their bills early. This results in
the firm receiving the cash earlier.
The goal here is to put off the payment of cash for as long as possible and to manage
the cash being held. By using a JIT inventory system, a firm is able to avoid paying for
the inventory until it is needed while also avoiding carrying costs on the inventory. JIT is
a system where raw materials are purchased and received just in time, as they are
needed in the production lines of a firm.
Types of Working Capital
Working capital, as mentioned above, can take different forms. For example, it can take the
form of cash and then change to inventories and/or receivables and back to cash.
Gross and Net Working Capital: The total of current assets is known as gross
working capital whereas the difference between the current assets and current
liabilities is known as the net working capital.
Permanent Working Capital: This type of working capital is the minimum amount
of working capital that must always remain invested. In all cases, some amount of
cash, stock and/or account receivables are always locked in. These assets are
necessary for the firm to carry out its day to day business. Such funds are drawn
from long term sources and are necessary for running and existence of the business.
Variable Working Capital: Working capital requirements of a business firm might
increase or decrease from time to time due to various factors. Such variable funds
are drawn from short-term sources and are referred to as variable working capital.
Properties of A Healthy Working Capital Cycle
It is essential for the business to maintain a healthy working capital cycle. The following
points are necessary for the smooth functioning of the working capital cycle:
Sourcing of raw material: Sourcing of raw material is the beginning point for
most businesses. It should be ensured that the raw materials that are necessary
for producing the desired goods are available at all times. In a healthy working
capital cycle, production ideally should never stop because of the shortage of raw
Production planning: Production planning is another important aspect that
needs to be addressed. It should be ensured that all the conditions that are
necessary for the production to start are met. A carefully constructed plan needs
to be present in order to mitigate the risks and avert unforeseen issues. Proper
planning of production is essential for the production of goods or services and is
one of the basic principles that must be followed to achieve smooth functioning of
the entire production lifecycle.
Selling: Selling the produced goods as soon as possible is another objective that
should be pursued with utmost urgency. Once the goods are produced and are
moved into the inventory, the focus should be on selling the goods as soon as
Payouts and collections: The accounts receivables need to be collected on
time in order to maintain the flow of cash. It is also extremely important to ensure
timely payouts to the creditors to ensure smooth functioning of the business.
Liquidity: Maintaining the liquidity along with some room for adjustments is
another important aspect that needs to be kept in mind for the smooth functioning
of the working capital cycle.
Approaches to Working Capital Management
The short-term interest rates are, in most cases, cheaper compared to their long-term
counterparts. This is due to the amount of premium which is higher for short term loans.
As a result, financing the working capital from long-term sources means more cost.
However, the risk factor is higher in case of short-term finances. In case of short-term
sources, fluctuations in refinancing rates are a major cause for concern, and they pose
a major threat to business.
There are mainly three strategies that can be employed in order to manage the
working capital. Each of these strategies takes into consideration the risk and
profitability factor and has its share of pros and cons. The three strategies are:
The Conservative Approach: As the name suggests, the conservative strategy
involves low risk and low profitability. In this strategy, apart from the permanent
working capital, the variable working capital is also financed from the long-term
sources. This means an increased cost capital. However, it also means that the
risks of interest rate fluctuations are significantly lower.
The Aggressive Approach: The main goal of this strategy is to maximize profits
while taking higher risks. In this approach, the entire variable working capital,
some parts or the entire permanent working capital and sometimes the fixed
assets are funded from short-term sources. This results in significantly higher
risks. The cost capital is significantly decreased in this approach that maximizes
the profit.
The Moderate or the Hedging Approach: This approach involves moderate
risks along with moderate profitability. In this approach, the fixed assets and the
permanent working capital are financed from long-term sources whereas the
variable working capital is sourced from the short-terms sources.
Significance of Adequate Working Capital
Maintenance of adequate working capital is extremely important because of the
following factors:
Adequate working capital ensures sufficient liquidity that ensures the solvency of
the organization.
Working capital ensured prompt and on-time payments to the creditors of the
organization that helps to build trust and reputation.
Lenders base their decisions for approving loans based on the credit history of
the organization. A good credit history can not only help an organization to get
fast approvals but also can result in reduced interest rates.
Earning of profits is not a sufficient guarantee that the company can pay
dividends in cash. Adequate working capital ensures that dividends are regularly
A firm maintaining adequate working capital can afford to buy raw materials and
other accessories as and when needed. This ensures an uninterrupted flow of
production. Adequate working capital, therefore, contributes to the fuller
utilization of resources of the enterprise.
Factors for Determining the Amount Of Working
Capital Needed
Factoring out the amount of working capital needed for running a business is an
extremely important as well as difficult task. However, it is extremely critical for any firm
to estimate this figure so that it can operate smoothly and be fully functional. There are
several factors that need to be considered before arriving at a more or less accurate
figure. The following are some of those factors that determine the amount of liquid cash
and assets required for any firm to operate smoothly:
Nature of business: A trading company requires large working capital. Industrial
companies may require lower working capital. A banking company, for example,
requires the maximum amount of working capital. Basic and key industries,
public utilities, etc. require low working capital because they have a steady
demand and continuous cash-inflow to meet current liabilities.
Size of the business unit: The amount of working capital depends directly upon
the volume of business. The greater the size of a business unit, the larger will be
the requirements of working capital.
Terms of purchase and terms of sale: Use of trade credit may lead to lower
working capital while cash purchases will demand larger working capital.
Similarly, credit sales will require larger working capital while cash sales will
require lower working capital.
Turnover of inventories: If inventories are large and their turnover is slow, we
shall require larger capital but if inventories are small and their turnover is quick,
we shall require lower working capital.
Process of manufacture: Long-running and more complex process of
production requires larger working capital while simple, short period process of
production requires lower working capital.
Importance of labor: Capital intensive industries e.g. mechanized and
automated industries generally require less working capital while labor intensive
industries such as small scale and cottage industries require larger working