WORKING CAPITAL MANAGEMENT

What is Working Capital

Working capital management is the set of activities that are required to run day to day operations of the business
to ensure that cash is adequate to meet short term debt and upcoming operational expenses. Working Capital is
also known as circulating capital or revolving capital. It is a measure of company’s operational efficiency, liquidity
and short-term solvency.

Working capital is defined in terms of Net Working capital, i.e, Current assets - Current liabilities.

Working Capital Ratio refers to how much capital a company should maintain to achieve zero or possibly lower risk
in conducting its daily operational activities.

In order to better understand working capital management, lets have a brief look at Current Assets and Current
Liabilities. Current assets are those short-term assets that can be converted into cash easily and current liabilities
are those liabilities, which are due in near future generally, within a year.

Working Capital Formula

The Working capital formula can be understood with the help of the following:

As per Balance Sheet:

Net Working capital = Current Assets – Current Liabilities (excess of current assets over current liabilities, also
known as net current assets)

As per Operating Cycle / Working Capital Cycle:

A company’s operating cycle or working capital cycle typically consists of the following activities:

1. Purchases for business

2. Produces the product (Inventory)

3. Sells the product (Receivables)

4. Collect Money

Thus, Operating cycle or working capital cycle

is nothing but the period taken by the business
to convert cash (paid for purchases) back to
the cash (received from selling the goods). It is
also known as circulating capital because
current assets of the firm are changed from
one form to another, in an ordinary course of
business.

Thus, when the firm refers to negative working

capital they are basically referring to shortage
of current assets to meet current liabilities.
Working Capital Management Ratios

1. Working Capital Ratio 1: Current assets / Current liabilities

This is also known as the Current Ratio. This ratio tells us whether the company has adequate short-term
assets to cover its short term liabilities. Ratio below 1 indicates negative working capital. If the ratio is
around 2 it is considered satisfactory.

Example:
Current assets = $ 250,000
Current liabilities = $ 150,000
Working capital Ratio = $ 250,000/ $ 150,000 = 1.67

In this example, working capital ratio of 1.67 indicates that current liabilities are secured by 1.67 times of
the business current assets and it shows a health liquidity position. Working capital ratio above 2 indicates
underutilized assets and bad working capital management. Working capital ratio less than 1 indicates that
the firm’s current assets are not capable of meeting its short term liabilities and that the business is in
Jeopardy. In that case, it’s known as negative working capital (excess of current liabilities over current
assets)

2. Working Capital Ratio 2 - Inventory Conversion period: Average Inventory / Cost of sales/365
This indicates the average time to convert inventory into sales. Inventory is not sold as it is manufactured.
Thus stocking of inventory involves cost. Inventory conversion period represents the efficiency of
the company’s working capital management in holding the goods. They should not overstock and pay
higher maintenance costs and at the same time, they should maintain enough stock so as to meet
demands.

Less conversion period is better because the inventories are converted faster into sales. This working
capital ratio is very important for companies who deal in perishable stocks like food industry. Greater the
time it takes to sell the goods higher is the risk of obsolescence.

Example:
Opening Inventory = $ 50,000
Closing Inventory = $ 80,000
Cost of Goods Sold = $ 400,000
Average Inventory = (50,000+80,000)/2 = 65,000
Therefore, ICP = 65,000/400,000/365 = approximately 60 days

Thus, it takes 60 days for a company to convert its inventory into sales.

3. Working Capital Ratio 3 - Receivable Conversion period: Average Receivables / Net Credit sales/365
It is also known as average collection period. It represents how quickly the debtors can be converted into
cash during the period. In other words, it represents the average time between the sale of the goods on
credit and cash receipts of the same.

A fundamental concept of time value of the money is money received today is better than money to be
received in future.
 Cash sales are always better as the money comes to you today itself, however, business may have to
provide credit period to his debtors so as to increase its turnover, thus it involves an opportunity cost and
of course default risk but at the reward of increasing sales.

Example:
Opening Receivables = $ 20,000
Closing Receivables = $ 25,000
Credit Sales = $. 500,000
Returns = $ 20,000
Average Receivables = (20,000+250,00)/2 = 22,500
Net Credit Sales = 500,000 – 20,000 = 480,000
Therefore, ACP = 22,500/480,000/365 = approximately 17 days

It means cash is received on an average within 17 days of the credit sales. This can be compared with
normal credit policies of the business, which is generally laid down in the notes to financial statements of
the companies. Say if the credit policies specified is more than 17 days, it represents the efficient
collection management system and vice versa.

4. Working Capital Ratio 4 - Payable Turnover Ratio: Net Credit Purchases/Average Payables
It indicates the speed with which the payment is made to the supplier for the credit purchase during the
period. If this working capital ratio is declining over the period, it may signal worsening financial condition.

Example:
Average Payables = $ 50,000
Net Credit Purchases = $ 350,000
Payable Turnover Ratio = 350,000/50,000 = 7 times
To calculate the average number of days unpaid during the period, the Payable Turnover Ratio is divided
by 365 days, i.e, 365/7 = 52 days.
Therefore, on average the company repays amount to its creditors after 52 days of the credit
purchases.

Thus Operating cycle is Inventory conversion period + average collection period – average payment period
In this case = 60 + 17 – 52 = 25 days
Thus, it takes 25 days for the business to convert the cash back to cash. Operating cycle is continuous and
not discrete.

Working Capital Management Case Study. Let’s review a real life example of HUL – Hindustan Unilever Limited
(Consolidated)

Working Capital Ratios Year 2013 Year 2012

Current Ratio 0.78 0.86
Quick Ratio 0.47 0.47
Inventory Turnover Ratio 9.98 10.02
Debtors Turnover Ratio 29.14 25.78
Working Capital Days -26.61 -17.29

Working Capital Case Study Analysis

Current Ratio has decreased from 0.86 to 0.78 and Ratio is below 1 which indicates that the current assets are
inadequate to meet its short term liabilities and it does not in favor healthy short term financial condition.
It is to be noted that though current ratio has decreased, quick ratio is intact. It implies that the decrease in current
ratio is because of inventories {Quick ratio is nothing but (Current assets – Inventories – Prepaid Expenses)/Current
liabilities}

For 2013
Average conversion period = 365/9.98 = 37 days
Average collection period = 365/29.14 = 13 days
Average Payment period = 37 + 13 – X = -27 days, i.e, 77 days

For 2012
Average conversion period = 365/10.02 = 36 days
Average collection period = 365/25.78 = 14 days
Average Payment period = 36 + 14 – X = -17 days, i.e, 67 days

From the above figures, it can be seen that there is no significant change in conversion and collection period,
however working capital has increased from -17 days to -27 days, which I relate to increase in average payment
period from 67 days to now 77 days, which is again not in the favor of the company.

Working Capital Management Strategies

Working capital management directly affects the firm’s long term growth and survival. A company may be
profitable and it may have sufficient assets, but short of liquidity may endanger its goodwill.

Management should make sure that they have adequate working capital so as to manage its daily activities and
upcoming operational expenses. There is high risk and uncertainty involved in managing the working capital since
your debtors may not pay you at the time when you have to pay to your suppliers. At the same time, management
cannot keep excess capital as it leads to opportunity loss of the excess capital blocked and shortage of it can lead to
irreparable damage to the company in terms of lost suppliers due to delay in payments or lost customers due to
not meeting the demands as and when required which may also result in poor returns, high amount of bad debts
and low market value of shares.

Effective working capital management allows the company to invest in future growth, repay its current liabilities as
and when they become due and reduce financing costs. Thus, working capital management will involve managing
cash, inventories, receivable and short term financing.

Cash Management
Management needs to identify the cash balance required for the smooth functioning of the daily activities of the
business but at the same time also reduces cash holding costs.

Inventory Management
Management needs to identify the level of inventory which will allow smooth production but at the same time also
reduces ordering and carrying costs. Inventories should not be over produced as well so as to lower management
costs.

Management resorts to practices like Just in time and Economic order quantity for efficient Inventory Management
purposes.

Debtors Management
Management should identify the appropriate credit policy which will attract the sales such that any impact on the
cash flows will be offset by higher sales.

Short Term Financing

Management should also identify the appropriate source of financing. They should also compare the interest rate
paid on borrowings with Return on capital so as to take correct financing and investment decisions
Sources of Working Capital

1. Own Funds
2. Bank Borrowings
3. Sundry Creditors
4. Advance from customers
5. Deposits due in a year
6. Pre received Income
7. Other Current Liabilities

Working capital management is more critical for those industries which seek higher liquidity for their daily
operational activities or by nature whose operating cycle is higher - such as technology firms because goods take
time to produce and it is reasonable to expect these firms to have a large value of inventories with long production
processes.

Financial Analysts manage and optimize working capital without compromising on the company’s potential sales
and profits. The Analyst should forecast the amount required to acquire fixed assets and meet working capital
needs and can carry out sensitivity analysis and assess the severity of underinvestment due to negative working
capital. It may also be possible that at point of time the short term solvency of the company is not good but that
does not mean that it is a bad management or bad investment. For eg. If company today is not able to pay their
supplier that does not mean it will not pay in future. In such cases, the analyst will have to look at the true picture
of the financial conditions, quality of management and make their own judgements. They should implement
processes and systems to evaluate inventory productivity, minimize costs and maximize working capital.

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