Working Capital Management: Factors Affecting, Importance, Requirement, Strategies, Managing

What is Working Capital?

Working capital refers to monies invested in current assets. It is the capital that is required to run the business on a daily basis. Working capital, in general, refers to a company’s current assets that are converted from cash to inventory, inventory to Work in Progress (WIP), WIP to completed goods, finished goods to receivables and receivables to cash in the usual course of business.

Working capital is divided into two categories:

• Gross working capital: Gross working capital is a word that refers to the whole of a company’s current assets. Therefore, Stock + Debtors + Receivables + Cash equals gross working capital
  
  
• Net working capital: The difference between a company’s current assets and current liabilities is known as net working capital.

Hence,

Stock + Debtors + Receivables + Cash – Creditors – Payables = Net Working Capital

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Factors Affecting Working Capital

A firm must appropriately estimate its working capital since excess working capital leads to excess inventory and wastage of capital, whereas a lack of working capital disrupts the smooth flow of the operating cycle and causes the business to fail to meet its commitments.

As a result, the finance manager must calculate the correct amount of working capital. Before determining the quantity of working capital, the finance management must consider the following elements:

Operating cycle duration

The quantity of working capital required is directly proportional to the length of the operating cycle. The time period involved in manufacturing is referred to as the operating cycle. It begins with the procurement of raw materials and continues until money is received following the sale.

Business nature

The sort of business that the company is in is the second factor to consider when deciding on working capital.

Operational scale

Inventory, debts and other assets are all more important in large enterprises. As a result, they frequently require a large quantity of operating capital, whereas small enterprises just require a modest amount.

Fluctuation in the business cycle

When the market is booming, there is more demand, more production, more inventory and more debtors, all of which need more working capital. When demand is low, there is fewer inventory to maintain and fewer debtors, therefore, less working capital is necessary.

Seasonal variables

Companies that sell goods throughout the season require a constant amount of working capital, whereas companies that sell seasonal goods require a large amount of working capital during the season because there is more demand, more stock must be maintained and fast supply is required, whereas demand is very low during the off-season or slack season, so less working capital is required. Study Hint The ideal position to have a positive net working capital balance is to have more current assets than current liabilities.

Technology and the manufacturing process

If a company uses a labour-intensive method of production, it will require more working capital because it will need to keep enough cash flow to pay employees.

Credit permitted

The average duration for collecting sale profits is referred to as credit policy. If a firm has a liberal credit policy, it will require more working capital, while, if the company has a stringent or short-term credit policy, it would require less working capital.

Avail credit

Another aspect of credit policy is the amount and length of credit that a firm receives from its suppliers. If raw material suppliers provide long-term credit, the firm can operate with less working capital, however, if suppliers only provide short-term credit, the company will need more working capital to pay creditors.

Operational effectiveness

When a corporation operates at a high level of efficiency, it requires less working capital than when it operates at a low level of efficiency, which necessitates more. Firms with a high level of efficiency produce less waste and may operate with fewer inventories. They also incur less expenditure throughout the course of the business cycle, allowing them to operate with less cash.

Raw material availability

Firms may operate with less working capital if raw materials are readily available and there is a quick supply of raw materials and inputs.

Competition level

If the market is competitive, a company’s credit policy must be flexible and items must be delivered on time. To maintain more inventories, more working capital is necessary.

Inflation

When prices rise, the cost of raw materials and labour rises, resulting in a rise in working capital requirements. However, if the corporation is able to raise the price of its own items as well, there will be less working capital difficulty. The impact of a price increase on working capital will fluctuate depending on the type of business.

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Importance of Adequate Working Capital

Adequate working capital means an amount of working capital sufficient to meet day-to-day operational activities of the business concern under normal situations. No business can run successfully without an adequate amount of working capital. If an enterprise has adequate working capital, it can carry on its affairs without any financial stringency and economically. It will also be ready to face losses and unforeseen emergencies without inviting any disaster.

Following points explain the importance of adequate working capital:

Solvency of the business

A sufficient amount of working capital enables a continuous flow of manufacturing. The finished items may be sold, resulting in a rise in sales turnover and enough cash on hand. The business’s solvency is preserved in this way.

Cash discount

If the firm maintains a healthy cash position, it can take advantage of the cash discount programmes given by its suppliers.

Goodwill

When a company’s solvency is maintained, it is much easier for it to make payments on time. If this is the case, the company’s goodwill will be established and preserved in the future.

Liquidity

The level of working capital requirements, i.e., suitable working capital, may be determined by a skilled businessperson. In this case, appropriate working capital is used to keep the company concern’s liquidity intact.

Easy loan

If a company maintains a high level of solvency and goodwill, banks and financial institutions are willing to extend credit, i.e., a loan, on advantageous conditions. The company can simply obtain a loan in this manner.

Meeting unseen contingencies

It offers finances for unanticipated situations so that a company may properly deal with them. The impact of contingencies on corporate operations can be minimised to the greatest extent possible.

Regular supply of raw materials

A sufficient amount of working capital assures a steady supply of raw materials and a smooth flow of manufacturing.

High morale

Employee efficiency improves as a result of the usage of money, resulting in better earnings. Employee morale is maintained as a result of this strategy.

Regular payment of commitments

Wages and salaries, as well as other day-to-day running expenditures, should be paid on time. It is only feasible because appropriate operating capital is maintained. Regular payment of obligations improves employee productivity, minimises waste, lowers expenses and boosts output and profitability.

Good relations with banks and financial institutions

If a company has enough operating capital, it may return its loan with interest before the due date. This approach maintains positive relationships with banks and financial organisations.

Exploitation of favourable market conditions

The market is now set up in such a way that bulk purchases may benefit from trade discounts and inexpensive prices. These kinds of advantageous market situations can only be taken advantage of if sufficient operating cash is kept on hand.

Increased productivity of fixed assets

In most cases, fixed assets are purchased to increase a company’s earning capability. As a result, fixed assets must be effectively utilised. With sufficient working capital, fixed assets may be efficiently utilised to boost production.

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Working Capital Requirement

A company’s working capital need is the amount of money required to bridge the gap between its payable and receivable accounts. It is the amount of money that a company needs to stay viable.

Permanent Working Capital

Permanent working capital refers to the amount of current assets that must be maintained and are necessary for a company to operate its activities, regardless of their size. Permanent working capital refers to the amount of current assets that must be maintained and is necessary for a company to operate its activities, regardless of its size.

Temporary Working Capital

Temporary working capital is a type of working capital that exists in addition to permanent working capital. It is required to fulfil seasonal and short-term requirements. Fluctuating or variable working capital is another name for it. It is a type of short-term working capital that’s employed for one-time or seasonal demands.

Temporary working capital swings grows and decreases at different periods. Only for seasonal labour, this is a temporary fund. Temporary working capital will only be used for certain purposes, such as product advertisement.

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Working Capital Management Strategies

Different aspects of working capital, such as accounts receivable, cash, inventory and so on, must be managed to manage a company’s working capital. Let’s look at how each of these components is handled to get the best level of working capital.

Inventory Control

Inventory is a significant component of many organisations’ operating capital.

The phrase inventory refers to the following items:

• Finished items offered for sale by a company
• Components that are used to make final things (raw materials, work-in-progress and so on)

Raw materials are the components used to create commodities that are then processed into final goods. Finished goods, on the other hand, are things that are ready to sell. The type of inventory and quantity of components to be stocked now are determined by the nature of the business. Inventory management refers to allocating the most appropriate amount of working capital to inventory. This indicates that the investment is neither too low nor excessively large.

To establish the optimal level of inventory, a firm uses a variety of methods. Among them are:

Economic Order Quantity

The Economic order quantity to reduce inventory expenses, such as holding costs, shortfall costs and order costs is called an economic order quantity, or EOQ. Ford W. Harris created this production-scheduling concept in 1913 and it has since been improved. Demand, ordering and holding expenses are all considered constant in the calculation.

Calculating Economic Order Quantity (EOQ)

Calculating economic order quantity calls for algebra at the high school level. Calculating the EOQ is simple once you have the variables from your inventory management system. These calculations, including order expenses like inventory ordering charges, holding costs and stock-out costs, may all be taken care of for you when you employ a powerful ERP.

Three Variables (or Inputs) Used to Calculate EOQ

There are several variations of the formula used to calculate EOQ. One popular EOQ formula is based on these variables, also called inputs:

1. D = Demand in units (annual)
2. S = Order cost
3. H = Holding costs (per unit, per year)
Economic Order Quantity (EOQ)

Formula EOQ = √[2DS / H]

ABC Analysis

The value of inventory items is calculated using the inventory management approach of ABC analysis based on their significance to the company. Inventory managers classify things according to how ABC prioritises them based on demand, cost and risk data. This enables business executives to comprehend which offerings are most essential to the financial performance of their company.

According to sales volume or profitability, “Class A” items are the most crucial stock keeping units (SKUs), followed by “Class B” and “Class C” products. Some businesses could choose for a classification scheme that divides goods into more than just those three categories (A-F, for example).

The ABC analysis used for inventory management is distinct from the ABC analysis used for cost accounting, also known as activity-based costing. Activity-based costing is a manufacturing technique used by accountants to allocate indirect or overhead expenses, like wages or utility costs, to goods and services.

Use this formula for ABC inventory analysis:

Annual number of items sold × Cost per item = Annual usage value per product

In order to comprehend the market and formulate your company strategies, ABC analysis may also be done for the client or customer base. The four main parameters of revenue potential, support expenses, sales revenue and contribution margin may be used to create an ABC analysis example for clients.

Implementing the ABC analysis for customers

Beginning with charts based on the four main categories listed above, you may implement ABC analysis for your clients. Compare the charts once they have been created, particularly the charts for sales revenue and contribution margin. Sort and rank your clients into the A, B and C categories.

The consumers in Category A will be your most valued ones. Now, since these clients are the ones that will generate a significant amount of income and account for a significant chunk of the contribution margin, they should ideally be near to their maximum revenue potential.

The clients in Category B are a different group, of lower value but nonetheless necessary. These clients are devoted and will frequently spend a sizable sum of money with you. You should never anticipate them to spend a lot, though.

The remaining clients are automatically categorised under Category C. Customers are those who occasionally visit and make purchases here. However, this can also apply to regular consumers who make a lot of little purchases. Although these clients will undoubtedly make purchases at your business, they won’t have a significant influence on your earnings. These clients have lower potential.

When it comes to understanding your clients, the sales data by themselves can be highly deceptive. You could be fooled into thinking that a customer is valued when they are not by seeing them make a tiny transaction once or twice a week. Drive your view more toward the actionable facts rather than the sales metrics. You’ll be able to make more profitable judgments as a result of this.

Just-in-Time (JIT)

Using a just-in-time (JIT) inventory system, suppliers may place orders for raw materials that are directly in line with production schedules. By only ordering the things they need for the production process, businesses may cut down on inventory expenses while increasing efficiency and reducing waste. Producing using this technology necessitates precise demand forecasting.

Here are three examples of JIT inventory systems:

• Toy manufacturer: A toy company has decided to develop a JIT system for purchasing various types of plastic in quantity to bounce back from a bad fiscal year. Producers assess the bare minimum supplies required to create toy lines for a single month using the new methods and objectives in place. In the past, they placed orders for six months’ worth of goods, stockpiling the extra in warehouses until they were needed. Storage warehouses are no longer required. They no longer have to pay for those facilities with rent or property taxes.
  
  Due to a lack of demand for many trucks, the toy firm sells more than half of its transport fleet. Gas, payments and other costs related to the fleet were greatly reduced. Within six months, the toy manufacturer achieves a better financial state as a result of these cost reductions.
  
  
• Car company: To save expenses, a large automaker devel- ops a JIT system. In the past, they placed bulk orders for the parts and had an extra supply on hand. However, the number of parts ordered and the number of client orders received were not always equal.
  
  
• A proposal to only order items that consumers actually required was put forth by employees. By having less goods on hand at once, the automaker can conserve space. As they only place orders when clients want them, product costs decline. They immediately observe a change in the things they order, earning a profit.
  
  
• Restaurant: A neighbourhood eatery plans to use a JIT approach to save expenses. They used to order food a month in advance and store extra in freezers. Over time, capacity became a problem, leading to the loss of thousands of dollars’ worth of food in a single year. The owner decided to place food orders only once a week after calculating how much they could sell each week.
  
  The freezer is still not full even with the new equipment in place. Dry food no longer requires as much room as it formerly did, allowing the restaurant to add more workplaces. This increases kitchen productivity and raises diners’ levels of satisfaction.

Inventory Turnover ratio

The stock turnover ratio, sometimes referred to as the inventory turnover ratio, is a productivity ratio that assesses the effectiveness of inventory management. To determine how frequently inventory is “turned” or sold over the course of a period, the inventory turnover ratio formula is equal to the cost of products sold divided by total or average inventory. The ratio can be used to assess whether inventory levels are out of proportion to sales.

Inventory Turnover Ratio Formula

The formula for calculating the ratio is as follows:

Inventory Turnover Ratio = Cost of goods sold / Avg Inventory

Where:

• Cost of goods sold is the cost attributed to the production of the goods that are sold by a company over a certain period. The cost of goods sold by a company can be found on the company’s income statement.
  
  
• Average inventory is the mean value of inventory throughout a certain period.

Managing Cash

The most liquid of all current assets are cash. All current assets, like receivables and inventories, are eventually transformed into cash. As a result, cash management is critical. In addition, cash management is a crucial aspect of working capital management.

Accounts Receivable Management

Debtors emerging from the sale of products on credit to clients are referred to as accounts receivable. To boost sales and attract customers, a company must sell things on loan. Credit sales, on the other hand, carry a certain amount of risk. The danger of bad debts is referred to as this risk. It is accomplished by weighing the advantages and disadvantages of keeping such receivables.

As a result, putting too much money into accounts receivable boosts sales. A company can use the following strategies to manage its accounts receivable:

• Clearly stating credit policies to give credit to clients. Setting credit requirements, credit conditions, giving discounts and assessing client credit risk are all part of this process.
  
  
• Following a credit collection policy that assists a firm in collecting past-due payments.
  
  
• Accounts receivable should be monitored regularly to ensure that clients are paying according to credit conditions.

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Managing Working Capital

Working capital management is a business strategy for ensuring that a company runs smoothly by tracking and optimising its current assets and obligations. Ratio analysis may be used to measure the efficiency of working capital management.

Important Points to Remember

• Working capital management keeps track of a company’s assets and liabilities to ensure that it has enough cash flow to cover its short-term operational expenditures and debt commitments.
  
  
• Working capital management includes keeping track of a variety of ratios, such as the working capital ratio, collection ratio and inventory ratio.
  
  
• By effectively utilising a company’s resources, working capital management may enhance cash flow management and profit quality.

How Much Working Capital is Needed?

To answer this issue, you must first comprehend how money moves through your company – in other words, your “working capital cycle.” The cycle is made up of two parts: (1) how rapidly current assets (such as receivables and inventories) are converted to cash and (2) how quickly that cash is utilised to pay current liabilities (for example, accounts payable). For accounts receivables, inventories and accounts payable, the working capital cycle is also known as Turnover Rates.

Small businesses that have been profitable for a while will almost certainly have reinvested some of their profits back into the company (“retained earnings”).

Forecasting Working Capital Needs

The six phases involved in projecting working capital requirements are explained as follows:

• Obtaining the following data that has an impact on working capital requirements.
  
  This data can include:
  • The anticipated output for the year.
    
    
  • The projected cost per unit of production of raw materials, labour and overheads. ‰
    
    
  • The amount of time raw materials will be kept in storage before being used in the manufacturing process.
    
    
  • The amount of time the WIP will be processed or converted during the manufacturing process.
    
    
  • The amount of time that finished items will be stored in a warehouse before being sold.
    
    
  • The credit period permitted for credit sales.
    
    
  • The credit period granted by creditors for the purchase of raw materials on credit.
    
    
  • The time it takes for salaries and overheads to be paid.
    
    
  • The debtors’ profit element is included.
    
    
  • The type of production and the amount of overhead that accumulates over the course of the year.
    
    
• Calculating the average expected output (week, fortnight or month, etc.)
  
  
• Calculating the average estimated cost of each cost factor, such as material, labour and overheads, for a given period (week, fortnight, month, etc.).
  
  
• Calculating the net block time for each cost component such as material, labour and overhead.
  
  
• Multiply each cost element’s netblock period by their average periodical cost individually. This will determine the amount of working capital required for each cost component.
  
  If the netblock term of material is 8 months and the monthly cost of raw material is ₹10,000, the raw material working capital required is (8 × ₹10,000) or `₹80,000. Working capital requirements for wages and overheads will have to be determined in this manner.
  
  
• Finally, multiply the overall working capital demand by the item-by-item working capital requirement. Working capital requirements can sometimes be calculated from both a trading and a production perspective.