In estimating working capital needs, different people adopt different approaches. Some experts suggest that the working capital should be greater than the minimum requirements of the firm. The management should feel safety. It would be able to meet its obligations even in adverse circumstances. However, the excessive capital may lead to waste and inefficiency. On the other hand, some experts suggest that the working capital should be lower than the requirement so that no idle funds shall be invested in the current assets and it ultimately leads to increase in profitability of the company. However, in such case the firm always have risk of technical insolvency as it may not meet its obligations as and when they falls due for payment.
There are various approaches which have been applied in practice for the estimation of working capital requirements of a firm. Let’s discuss some of them in brief.
1. Conservative Approach
The conservative approach states that the proportion of current assets to current liabilities should be kept at 2:1. Is this proportion is to be kept the firm would be able to meet its obligations on time and hence its financial solvency would not be in trouble. However, the limitation of this approach is that it suggests only quantitative measure. It does not suggest as to what type of assets are to be included in current assets. If the current assets contain stock, which is outdated or receivable which are not collectable, than the amount of current assets has no meaning. Further, in the present scenario no firm maintains this ratio, as it’s too difficult for them to maintain such a high level of current assets.
2. Components Approach
Here we take up one of the planning models of working capital to estimate working capital. The method adopted here attempts at estimation of working capital and its components by taking into account, the period for which the various items remain as stock or as outstanding, the cost structure of production and annual production. It assumes even production and even sales, throughout and what is produced is completely sold.
3. Operating Cycle Approach
It was earlier referred to that working capital is also known as revolving capital. That is, a circular path of conversion/re-conversion takes place. Consider this example. You start your business operation with an initial investment. With credit extended by expense creditors (labor, employees, utilities, etc.) you start production process. Goods of varying levels of finish result. This is what we call as work-in-process or work-in-progress. Once complete processing is done, you get finished goods. Until these goods are sold, they remain in stock. Sales may be for cash and/or on credit basis. You need to wait a little to realize cash from the credit customers. The realized cash is used to pay creditors. You need to maintain a cash balance for day-to-day transactions as well as for meeting sudden spurt in payment obligations accompanied by sluggish cash collections from debtors. Thus a revolution or cycle from cash to raw materials to Work in Progress (WIP), to finished goods, to debtors, and back to cash is taking place. This revolution or cycle is known as operating cycle.
Efficient working capital management is one which ensures continuous flow without any interruptions/holdups at any of the stages referred to above and involves as for as possible a rapid completion of the revolutions. In other words, when raw materials remain in store pending issue for production for a less duration, when raw materials get converted into WIP in short duration, when WIP is converted into finished goods in short duration, when finished goods remain in dept pending sales for a short while only, and when cash realizations out of sales are made quickly and finally when payment to creditors is made slowly, the operating cycle would be smaller and consequently the working capital will also be reasonable.
There should be neither too little nor too much investment in working capital. Efficient handling of the operating cycle would make possible the above. Note, what is suggested is optimization, and not minimization of current assets and maximization of current liabilities. That will affect your liquidity and your profitability. Too little means more illiquid, but more profitability, but not more absolute profits. We want both high profitability and high profits. Too much current liability means illiquid but more profitability as it is assumed short-term funds are less expensive for they can be redeemed the moment you don’t need thus saving interest. The reverse is true with too little current liability. Actually the business has to trade-off between risk and return. If it wants less risk it has to carry more current assets and less current liability. This will lead to lower profits. Low risk means low profits. If the business takes more risk, ie., it carries less working capital, it might make more profits. There is no guarantee however that higher level of risk yields higher profits.
In terms of operating cycle concept, too long an operating cycle gives more liquidity but only low returns and vice versa. The optimum operating cycle has to be worked out taking into account the costs and benefits and levels of risk and levels of return for varying lengths of operating cycle.