A. Working capital
Working capital refers to a measurement of a company’s short-term financial health, representing the
funds available for the day-to-day operations and short-term obligations.
Working Capital = Current Assets - Current Liabilities
Current assets short term assets like cash, accounts receivable and inventory, while current liabilities
encompass short-term debts, payables, and other obligations due within a year.
Working capital ratio if 2:1 would generally be considered a healthy ratio, but in some industries or kinds
of businesses, a ratio as low as 1.2:1 may be adequate.
A company has positive working capital if it has enough cash, accounts receivable and other liquid assets
to cover its short-term obligations, such as accounts payable and short-term debt.
In contrast, a company has negative working capital if it doesn’t have enough current assets to cover its
short-term financial obligations. A company with negative working capital may have trouble paying
suppliers and creditors and difficulty raising funds to drive business growth. If the situation continues, it
may eventually be forced to shut down.
B. Importance of Working Capital
1. To smooth fluctuation in sales and short term profits
Working capital can help smooth out fluctuations in revenue. Many businesses experience some
seasonality in sales, selling more during some months than others, for example. With adequate working
capital, a company can make extra purchases from suppliers to prepare for busy months while meeting its
financial obligations during periods where it generates less revenue.
For example, a retailer may generate 70% of its revenue in November and December — but it needs to
cover expenses, such as rent and payroll, all year. By analyzing its working capital needs and maintaining
an adequate buffer, the retailer can ensure it has enough funds to stock up on supplies before November
and hire temps for the busy season while planning how many permanent staff it can support.
Also a business can invest extra working capital to create short-term profits rather than keeping a heavy
amount of funds as working capital, which may not be necessary.
2.
Liquidity Management and Cash Flow Management
Working capital guarantees that a business has adequate cash on hand to meet its short-term financial
responsibilities, e.g., paying suppliers, employees, rent, and other costs., The financial team of an
enterprise would plan for their funds by analyzing the expenses payable or to be incurred in the near
future.
Efficient management of working capital can help companies manage their cash flows better, which is
critical to their survival and growth. Inappropriately planned day-to-day expenses may result in enterprise
liquidity issues.
If a company has enough working capital, it can continue to pay its employees and suppliers and meet
other obligations, such as interest payments and taxes, even if it runs into cash flow challenges.
Working capital can also be used to fund business growth without incurring debt. If the company does
need to borrow money, demonstrating positive working capital can make it easier to qualify for loans or
other forms of credit.
3. Company’s culture and creditworthiness
Timely payment of salaries and other day-to-day expenses creates a good working environment, which
motivates employees to work harder and strengthens the company’s culture. Furthermore, adequate
working capital planning ensures timely payments to creditors, which improves the business’s
creditworthiness and makes it easier to obtain funds when required.
4. Value Addition and Good Reputation
Proper management of working capital helps the business pay its outstanding debts on time,
creating goodwill and adding value in the market.
Maintaining a good reputation in the market due to timely payments and fulfilling commitments helps the
business easily obtain contracts and generate more business. A business with a good reputation can act as
a guarantor for other enterprises, which can help it secure more contracts and generate more profits.
5. Business Growth
Having enough working capital helps a business in its growth and expansion. Working capital can
facilitate a business to invest in novel projects, extend its operations, and capitalize on emerging growth
opportunities. Contrarily, a lack of working capital in a business can hinder growth efforts and limit its
ability to compete in the market.
6. Liquid assets
Inventory and Production: A well-managed working capital enables a company to maintain optimal
inventory levels. It ensures that production can continue without interruptions and that customers'
demands can be met promptly.
Accounts Payable and Receivable: Proper working capital management helps balance the time it takes to
collect payments from customers (accounts receivable) and the time it takes to pay suppliers (accounts
payable). This equilibrium prevents cash flow problems.
C. Factors affecting WC
Working capital is a crucial financial metric that represents the operational liquidity of a business – its
ability to cover short-term obligations and fund day-to-day operations. Several factors can impact
working capital, some important ones related to credit availability, operating efficiency, availability of
raw materials, growth prospects, competition level, and inflation.
1. Credit Availability:
Credit Terms from Suppliers: If suppliers offer favorable credit terms, it can extend the time a business
has to pay its bills, effectively increasing its working capital.
Another factor related to credit policy is how much and for how long period company is getting credit
from its suppliers. If suppliers of raw materials are giving long term credit then company can manage
with less amount of working capital whereas if suppliers are giving only short period credit then company
will require more working capital to make payments to creditors.
2. Credit Policies:
A business's credit policy toward customers can impact receivables. Stricter credit policies might result
in quicker collection, while more lenient policies might lead to delayed payments.
Credit policy refers to average period for collection of sale proceeds. It depends on number of factors
such as creditworthiness, of clients, industry norms etc. If company is following liberal credit policy then
it will require more working capital whereas if company is following strict or short term credit policy,
then it can manage with less working capital also.
3. Operating Efficiency:
Inventory Management: Efficient inventory management reduces the amount of capital tied up in unsold
goods. Holding excess inventory ties up working capital, while inadequate inventory can lead to
stockouts.
The firm having high degree of operating efficiency requires less amount of working capital as compared
to firm having low degree of efficiency which requires more working capital. Firms with high degree of
efficiency have low wastage and can manage with low level of inventory also and during operating cycle
also these firms bear less expense so they can manage with less working capital also.
4. Accounts Receivable Management:
Quick collection of outstanding payments from customers enhances working capital. Delays in collection
negatively affect liquidity.
5. Availability of Raw Materials:
Supply Chain Disruptions: Shortages of raw materials due to supply chain disruptions can lead to
production delays, affecting sales and working capital.
If raw materials are easily available and there is ready supply of raw materials and inputs then firms can
manage with less amount of working capital also as they need not maintain any stock of raw materials or
they can manage with very less stock. Whereas if the supply of raw materials is not smooth then firms
need to maintain large inventory to carry on operating cycle smoothly. So they require more working
capital.
6. Competition Level:
Pricing Pressure: In highly competitive markets, businesses might lower prices to attract customers,
potentially reducing profit margins and affecting available working capital.
If the market is competitive then company will have to adopt liberal credit policy and to supply goods on
time. Higher inventories have to be maintained so more working capital is required. A business with less
competition or with monopoly position will require less working capital as it can dictate terms according
to its own requirements.
7. Inflation:
Cost Inflation: Rising costs of raw materials, labor, and other expenses can squeeze profit margins and
affect working capital.
Pricing Power: Businesses with the ability to pass on cost increases to customers through higher prices
are better positioned to maintain their working capital.
If there is increase or rise in price then the price of raw materials and cost of labour will rise, it will result
in an increase in working capital requirement. But if company is able to increase the price of its own
goods as well, then there will be less problem of working capital. The effect of rise in price on working
capital will be different for different businessmen.
8. Growth Prospects:
Sales Growth: Rapid sales growth can strain working capital as increased demand requires higher
inventory and potentially longer receivable cycles.
Firms planning to expand their activities will require more amount of working capital as for expansion
they need to increase scale of production which means more raw materials, more inputs etc. so more
working capital also.
9. Seasonal sales
The companies which sell goods throughout the season require constant working capital. However, the
companies selling seasonal goods require a huge amount of working capital during the season, as at that
time there is more demand and the firm has to maintain more stock and supply the goods at a fast
speed, and during the off-season, it requires less working capital as the demand is low.
10. Technology and production cycle
A company using labour-intensive techniques requires more working capital because it has to maintain
enough cash flow for making payments to labour. However, a company using capital-intensive
techniques requires less working capital because the investment made by the company in machinery is
a fixed capital requirement, and also there will be less operating expenses.
D. Way to improve WC
How an organization can enhance its working capital in relation to each of the factors:
Part 1
1. Credit Availability: Negotiate Credit Terms: Negotiate longer credit terms with suppliers and shorter
terms with customers to create a favorable cash flow cycle. Utilize Financing: Utilize short-term
financing options like revolving credit lines to cover temporary shortfalls in working capital. Maintain
Good Relationships: Build strong relationships with lenders and financial institutions to ensure access to
credit when needed.
2. Operating Efficiency: Lean Operations: Implement lean principles to optimize processes, reduce waste,
and improve the efficiency of resource utilization. Automate Processes: Automate repetitive tasks to save
time and minimize errors in order to streamline operations. Employee Training: Provide training to
employees to enhance their skills and efficiency, leading to increased productivity.
3. Availability of Raw Materials: Supplier Relationships: Develop strong relationships with suppliers to
negotiate better terms, bulk discounts, and potentially longer payment periods. Diversify Suppliers: Work
with multiple suppliers to mitigate the risk of supply chain disruptions affecting raw material availability.
4. Growth Prospects: Scenario Planning: Develop scenarios for various growth trajectories to prepare for
changes in working capital requirements. Invest in Technology: Invest in technology solutions that can
scale with business growth, ensuring operational efficiency is maintained.
5. Competition Level: Product Differentiation: Focus on product differentiation to maintain pricing power
and potentially command higher prices, improving profit margins. Cost Control: Keep a close watch on
costs to maintain profitability in competitive markets without sacrificing quality.
6. Inflation: Pricing Strategy: Adjust pricing strategies to reflect increased costs due to inflation, ensuring
that profit margins are preserved. Hedging Strategies: Consider using hedging instruments to manage the
impact of volatile commodity prices on raw materials.
Remember, each organization's situation is unique, so it's important to tailor these strategies to your
specific industry, market conditions, and business model. Additionally, an integrated approach that
considers multiple factors together will likely yield the most effective results. Regularly monitoring and
reassessing your working capital strategies will help ensure your organization's financial health and
sustainability.
Part 2
A business may wish to increase its working capital if it, for example, needs to cover project-related
expenses or experiences a temporary drop in sales. Tactics to bridge that gap involve either adding to
current assets or reducing current liabilities.
Taking on long-term debt. This increases current assets by adding to the company’s available cash but
doesn’t overly increase current liabilities.
Refinancing short-term debt as longer-term debt. This reduces current liabilities because the debts are no
longer due within a year.
Selling illiquid assets for cash, thus increasing current assets.
Analyzing and reducing expenses, reducing current liabilities.
Analyze and optimize inventory management to reduce overstocking and the likelihood that inventory
will need to be written off.
Automate accounts receivable and payment monitoring. This can increase cash flow, reducing the need to
draw on working capital for day-to-day operations.
Part 3
Speed Up Collection for Accounts Receivable
The longer it takes for your business to get paid, the less cash you have on-hand. Plus, it increases the
chance that a customer doesn’t pay at all, which is even worse for your working capital. To avoid trouble,
set clear terms with clients for when you expect to get paid, consider scheduling earlier payment
deadlines and follow up with clients that are behind on their invoices.
Reduce Accounts Payable
Whether it’s negotiating for improved terms with creditors, paying early to qualify for supplier discounts
or just constantly searching for better vendors, anything you can do to reduce the amount owed for
accounts payable will help your working capital.
Refinance Debt to Better Terms
If you’ve got outstanding debt and the monthly payments are a strain on your budget, refinancing could
buy you some breathing room. This means replacing your current bills with another loan, at better terms.
If your credit score and business income have improved since you first took out these loans, you’re in a
good position to potentially qualify for a lower interest rate and lower payments.
Avoid Stockpiling Unnecessary Inventory
Even though inventory is technically a short-term asset, it’s not one you can immediately turn into cash
during an emergency. That’s why you should avoid holding unnecessary stores of unsold inventory. An
inventory management system could help you do that.
Maintain Financing Options
Sometimes working capital swings can still catch you off-guard. Having a business line of credit and/or
credit cards available can help you manage your expenses during tight working capital stretches.
Factoring, and invoice discounting
Working capital, factoring, and invoice discounting are all concepts related to managing cash flow and
liquidity within a business.
Working Capital: Working capital is the measure of an organization's ability to cover its short-term
operational expenses and obligations. It's calculated by subtracting current liabilities (short-term debts and
payables) from current assets (cash, accounts receivable, and inventory). Working capital is essential for
maintaining day-to-day operations, paying suppliers, and meeting other short-term financial
responsibilities. Effective working capital management involves optimizing the balance between current
assets and liabilities to ensure smooth operations and financial stability. Factoring:
Factoring is a financial arrangement where a business sells its accounts receivable (invoices) to a thirdparty company known as a "factor." The factor advances a portion of the invoice value to the business
upfront, typically around 70% to 90% of the invoice amount. The factor then assumes responsibility for
collecting payment from the customers. Once the customers pay the factor, the remaining balance is
remitted to the business, minus a fee for the factor's services. Factoring can provide immediate cash flow
and help businesses manage working capital by converting unpaid invoices into cash, even if the payment
from customers is delayed.
Invoice Discounting: Invoice discounting is a financing method similar to factoring, but with some key
differences. In invoice discounting, the business retains control over the collection process of its accounts
receivable. The business borrows money against the value of its outstanding invoices from a financial
institution, using the invoices as collateral. The business receives a percentage of the invoice value
upfront, and when the customers pay the invoices, the business repays the loan along with interest or fees.
Unlike factoring, the customers may not be aware that the invoices have been pledged as collateral.
Invoice discounting provides cash flow without directly involving a third party in the customer
relationship.
Key Differences:
Factoring involves selling invoices to a third-party factor, while invoice discounting involves borrowing
against the value of the invoices without transferring ownership.
Factoring includes collection services provided by the factor, whereas invoice discounting requires the
business to manage invoice collections.
Factoring can help businesses with weaker credit histories since the factor evaluates the creditworthiness
of the business's customers. Invoice discounting relies more on the business's creditworthiness.
Factoring can impact customer relationships, as customers are aware that a third party is collecting
payments. Invoice discounting allows the business to maintain control over customer relationships.
Both factoring and invoice discounting are methods for improving cash flow and managing working
capital, especially when a business faces cash flow gaps due to delayed customer payments.
The choice between the two depends on factors such as the business's relationship with customers, control
over collections, and creditworthiness.
Have a clear view of how much cash is on hand at any given time, and work with the business to maintain
sufficient working capital to cover liabilities, plus some leeway for growth and contingencies.
IMPORTANT: https://www.fundingoptions.com/knowledge/invoice-factoring-vs-invoice-discounting/
Others:
https://www.tatacapital.com/blog/loan-for-business/working-capital-meaning-importance-andadvantages/
https://www.yourarticlelibrary.com/management/top-13-factors-affecting-the-working-capital-of-acompany/8742