For increasing shareholder’s wealth a firm has to analyze the effect of fixed assets and current assets on its return and risk. Working Capital Management is related with the Management of current assets. The Management of current assets is different from fixed assets on the basis of the following points:
1. Current assets are for short period while fixed assets are for more than one Year.
>2. The large holdings of current assets, capitalforbusiness especially cash, strengthens Liquidity position but also reduces overall profitability, and to maintain an optimum level of liquidity and profitability, risk return trade off is involved holding Current assets.
3. Only Current Assets can be adjusted with sales fluctuating in the short run. Thus, the firm has greater degree of flexibility in managing current Assets. The management of Current Assets helps affirm in building a good market reputation regarding its business and economic condition.
Now first let us discuss the paradigms of Working Capital Management.
CONCEPT OF WORKING CAPITAL:
The concept of Working Capital includes Current Assets and Current Liabilities both. There are two concepts of Working Capital they are Gross and Net Working Capital.
1. Gross Working Capital: Gross Working Capital refers to the firm’s investment in Current Assets. Current Assets are the assets, which can be converted into cash within an accounting year or operating cycle. It includes cash, short-term securities, debtors (account receivables or book debts), bills receivables and stock (inventory).
2. Net Working Capital: Net Working Capital refers to the difference between Current Assets and Current Liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year. It includes creditors or accounts payables, bills payables and outstanding expenses. Net Working Copulate can be positive or negative. A positive Net Working Capital will arise when Courtney Assets exceed Current Liabilities and vice versa.
Concept of Gross Working Capital
The concept of Gross Working Capital focuses attention on two aspects of Current Assets’ management. They are:
a) Way of optimizing investment in Current Assets.
b) Way of financing current assets.
a. Optimizing investment in Current Assets: Investment in Current Assets should be just adequate i.e., neither in excess nor deficit because excess investment increases liquidity but reduces profitability as idle investment earns nothing and inadequate amount of working capital can threaten the solvency of the firm because of its inability to meet its obligation. It is taken into consideration that the Working Capital needs of the firm may be fluctuating with changing business activities which may cause excess or shortage of Working Capital frequently and prompt management can control the imbalances.
b. Way of financing Current Assets: This aspect points to the need of arranging funds to finance Country Assets. It says whenever a need for working Capital arises; financing arrangement should be made quickly. The financial manager should have the knowledge of sources of the working Capital funds as wheel as investment avenues where idle funds can be temporarily invested.
Concept of Net Working Capital
This is a qualitative concept. It indicates the liquidity position of and suggests the extent to which working Capital needs may be financed by permanent sources of funds. Current Assets should be optimally more than Courtney Liabilities. It also covers the point of right combination of long term and short-term funds for financing court Assents. For every firm a particular amount of net Working Capital in permanent. Therefore it can be financed with long-term funds.
Thus both concepts, Gross and Net Working Capital, are equally important for the efficient management of Working Capital. There are no specific rules to determine a firm’s Gross and Net Working Capital but it depends on the business activity of the firm.
Working capital management is concerned with the problems that arise while managing the current assets the current liabilities and the interrelationship that exits between them. Thus, the WC management refers to all aspects of a administration of both current assets the current liabilities.
Every business concern should not have neither redundant nor cause excess WC nor into should be short of W.C. both condition are harmful and unprofitable for any business. But out of these two the shortage of WC is more dangerous for the well being of the firms.
Impact/Harm of Redundant Or Excessive Working Capital
* Excessive WC means idle funds, which earn no profits for the business, cannot earn proper rate of return on its investment.
* When there is a redundant WC, it may lead to unnecessary purchasing and accumulation of inventories causing more chances if theft, waste and losses.
* Excessive WC implies excessive debtors and defective credit policy, which may cause higher incidences of bad debts.
* It may result into overall inefficiency in the organizations.
* When there is excessive WC relation with banks and other financial institutions may not be maintained.
* The redundant WC gives rise to speculative transaction.
* Due to low rate of return on investments the value of shares may also fall.
* In case of redundant WC there is always a chance of financing long terms assets from short terms funds, which is very harmful in long run for any organization.
Dangers of Short or Inadequate Working CapitalØ A concern, which had adequate WC, cannot pay its short-term liabilities in time. Thus it will lose its reputation and should be not be able to get good credit facilities.
* It cannot by its requirements in bulk and cannot avail of discounts. It stagnates growth.
* It becomes difficult for the firms to exploit favorable market conditions and undertake profitable projects due to non-availability of WC funds.
* The firm cannot pay day-to-day expenses of its operations and its credit inefficiencies, increases cost and reduces the profits of the business.
* It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid funds thus the firms profitability would deteriorate.
* The rate of return on investments also falls with the shortage of WC.
* Operating inefficiency creeps in and it becomes difficult to implement operating plans and achieve the firms profit targets.
Need for Working CapitalFor earning profit and continue production activity, the firm has to invest enough funds in Current Assets in generating sales. Current Assets are needed because sometimes sales do not convert into cash instantaneously and it includes an operating cycle.
Operating Cycle: Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. Investment in current assets such as inventories and debtors is realized during the firm’s operating cycle, which is usually less than a year.
The operating cycle of a manufacturing company involves three phases: –
1. Acquisition of resources such as raw material, labor, power and fuel etc.
2. Manufacture of the product which includes conversion into work-in-progress into finished goods.
3. Sale of the product either for cash or on credit.
These phases affect cash flows because sometimes sale is done on credit and it takes sometimes to realize.
Length or Duration of the Operating Cycle: The length of the operating cycle of a manufacturing firm in the sum of the following:
1.Inventory Conversion period
2. Debtors Conversion periods.
The total of Debtors Conversion Period and Inventory Conversion Period is referred to as Gross Operating Cycle.
1. Inventory Conversions Period: The Inventory Conversion Period is the total time needed for Producing and selling the product. It includes:
a. Raw Material Conversion Period.
b. Work-in-progress Conversion Period.
c. Finished Goods Conversion Period.
2. Debtors Conversion Period: It is the time required to collect the outstanding amount from the customers.
Net Operating Cycle: Generally, a firm may resources (raw materials) on credit and temporarily postpones payment of certain expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance investment in Courtney Assets.
The length of the time in which the firm is able to defer payments on various resource purchases is Payables Deferral period. The deference between Gross Operating Cycle and payables Deferral Period is called Net Operating Cycle. If depreciation is excluded from Net Operating Cycle, the computation repercussion represents Cash Conversion Cycle. It is net time interval between cash outflow.
Operating Cycle also represent the time interval over which additional funds, called Working Capital, should be obtained in order to carry out the firm’s operations. The firm has to negotiate Working Capital from sources such as banks. The negotiated sources of Working Capital financing are called non-spontaneous sources. If net Operating Cycle of a firm increases it means further need for negotiated Working Capital.
Calculation of Operating Cycle: The calculation of operating cycle helps to know the exact period of WC turnover i.e. how long it takes to convert cash again into cash? Through this calculation o