Management of Working Capital
There are two types of assets in each concern i.e., fixed assets and current assets. Both types of assets are to be manged efficiently so as to earn maximum profit with minimum possible investments because maximization of profits is the prime object of every business.
Decisions regarding investment in fixed assets are taken through the capital budgeting process but decision making regarding management of working capital is a continuous process which involves control of everyday and flow of financial resources circulating in the enterprise in one form or the other. The accomplishment of the prime objective – maximization of profits in most businesses depends largely how their working capital is managed. Working capital management is considered to involve the management of current assets, i.e., cash, accounts receivables and inventory. Unlike the management of fixed assets which may be arranged in special cases on long-lease basis, the working capital has no alternative except to arrange them and us them efficiently. There are certain special problems peculiar to the management of working capital requiring operational and financial skills of a high order.
Meaning of Working Capital Management
Every running business needs working capital. Even a business which is fully equipped with all types of fixed assets required is bound to collapse without (i) adequate supply of raw materials for processing; (ii) cash to pay for wages, power and other costs; (iii) creating a stock of finished goods to feed the market demand regularly; and, (iv) the ability to grant credit to its customers. All these require working capital. Working capital is thus like the lifeblood of a business. The business will not be able to carry on day-to-day activities without the availability of adequate working capital. The management of working capital or current assets is as important as or rather more, important than the management of fixed assets because the fate of most of the businesses very largely depends upon the manner in which their working capital is manged.
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 short-term 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. Working capital management entails short-term decisions, usually relating to the next one-year period and are based in part on cash flows and/or profitability.
The major problem of working capital management involves the problem of decision making regarding investment in various current assets with an objective of maintaining the liquidity of funds of the firm to meet its obligations promptly and efficiently. While managing the working capital, two characteristics of current assets should be kept in mind viz. (i) short life span, and (ii) swift transformation into other form of current asset. Each constituent of current asset has comparatively very short life span. Investment remains in a particular form of current asset for a short period. The life span of current assets depends upon the time required in the activities of procurement; production, sales and collection and degree of synchronization among them. A very short life span of current assets results into swift transformation into other form of current assets for a running business.
The management of working capital encompasses the following problems:
- To decide upon the optimal level of investment in various current assets, i.e., determining the size of working capital.
- To decide upon the optimal mix of short term funds in relation to long term capital, and
- To locate the appropriate means of short term financing.
The study of working capital management is incomplete unless we have an over-all look on the management of current liabilities. Determining the appropriate levels of current assets and current liabilities of level of working capital involves fundamental decisions regarding firm’s liquidity and the composition of firm’s debts.
Significance of Working Capital Management
Funds are needed in every business for carrying on day-to-day operations. Working capital funds are regarded as the life blood of a business firm. A firm can exist and survive without making profit but cannot survive without working capital funds. If a firm is not earning profit it may be termed as ‘sick’, but, not having working capital may cause its bankruptcy working capital in order to survive. The alternatives are not pleasant. Bankruptcy is one alternative. Being acquired on unfavorable term as another. Thus, each firm must decide how to balance the amount of working capital it holds, against the risk of failure.” Working capital has acquired a great significance and sound position in the recent past for the twin objects of profitability and liquidity. In period of rising capital costs and scare funds, the working capital is one of the most important areas requiring management review. It is rightly observed that, “Constant management review is required to maintain appropriate levels in the various working capital accounts.” Mainly the success of a concern depends upon proper management of working capital so “working capital management has been looked upon as the driving seat of financial manager.”
It consumes a great deal of time to increase profitability as well as to maintain proper liquidity at minimum risk. There are many aspects of working capital management which make it an important function of the finance manager. In fact we need to know when to look for working capital funds, how to use them and how measure, plan and control them.
Objectives of Working Capital Management
These are the two-fold objectives of the working capital management.
- Maintenance of working capital at appropriate level, and
- Availability of ample funds as and when they are needed.
In the accomplishment of these two objectives, the management has to consider the composition of current assets pool. The working capital position sets the various policies in the business with respect to general operations like purchasing, financing, expansion and dividend etc.
Importance of Working Capital Management
For smooth running an enterprise, adequate amount of working capital is very essential. Efficiency in this area can help, to utilize fixed assets gainfully, to assure the firm’s long- term success and to achieve the overall goal of maximization of the shareholders, fund. Shortage or bad management of cash may result in loss of cash discount and loss of reputation due to non-payment of obligation on due dates. Insufficient inventories may be the main cause of production held up and it may compel the enterprises to purchase raw materials at unfavorable rates.
Like-wise facility of credit sale is also very essential for sales promotions. It is rightly observed that “many a times business failure takes place due to lack of working capital.” Adequate working capital provides a cushion for bad days, as a concern can pass its period of depression without much difficulty. The adequacy of cash and current assets together with their efficient handling virtually determines the survival or demise of a concern. An enterprise should maintain adequate working capital for its smooth functioning. Both, excessive working capital and inadequate working capital will impair the profitability and general health of a concern.
The importance of the working capital management can be judged from the following facts;
- There is a positive correlation between the sale of the product of the firm and the current assets. An increase in the sale of the project requires a corresponding increase in current assets. It is, therefore, indispensable to manage the current assets properly and efficiently.
- More than half of the total capital of the firm is generally invested in current assets. It means less than half of the capital is blocked in fixed assets. We pay due attention to the management of fixed assets in details through the capital budgeting process. Management of working capital too, therefore, attracts the attention of the management.
- In emergency (Non availability of funds etc.) fixed assets can be acquired on lease but there is no alternative for current assets. Investment in current assets, i.e., inventory or receivable, can in no way be avoided without sustaining loss.
- Working capital needs are more often financed through outside sources, so it is necessary to utilize them in the best way possible.
Difference between the Working Capital Management and the Fixed Assets Management
In fact management of working capital is similar to that of fixed assets management in the sense that in both cases a firm analyses their effects on its profitability and risk. However, fixed assets management and working capital management differ in three important ways. Firstly, in managing fixed assets time is very important. Consequently, discounting and compounding aspects of time element play a significant role in capital budgeting and a minor one in the working capital management. Secondly, large holdings of current assets specially cash, strengthen a firm’s liquidity position (and reduce risks), but they also reduce overall profitability. Thirdly, the level of fixed as well as current assets depends upon the expected sales, but it is only current assets, which can be adjusted with sales fluctuations in the short-run.