Working Capital Management and BI – Part I
The perfect world does not require or concentrate about current assets or current liabilities because there would not be uncertainty, no transaction costs, information search costs, scheduling costs or production and technology constraints. The unit cost of production would not vary with the quantity produced. Capital, Labour and products markets shall be perfectly competitive and would reflect all available information. Thus in such an environment, there would be no advantage for investing in short term assets. Whereas, the world in which we live is not perfect. It is characterized by considerable amount of uncertainty regarding the demand, market price, quality and availability of own products and those of suppliers. There are transaction costs for purchasing or selling goods or securities. Information is costly to obtain and is not equally distributed. There are spreads between the borrowing and lending rates for investments and financing of equal risk. Similarly each organization is faced with its own limits on the production capacity and technology it can employ. There are fixed as well as variable costs associated with producing goods. In other words, the markets in which real firms operate are not perfectly competitive.
These real world facts introduce problems and require the necessity of working capital. The most important areas in the day to day management of the firm, is the management of working capital. Working capital management is the functional area of finance that covers all the current accounts of the firm. It is concerned with management of the level of individual current assets as well as the management of total working capital. Working capital management involves the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
For example, an organization may be faced with an uncertainty regarding availability of sufficient quantity of crucial inputs in future at reasonable price. This may necessitate the holding of inventory i.e., current assets. Similarly an organization may be faced with an uncertainty regarding the level of its future cash inflows and insufficient amount of cash may incur substantial costs. This may necessitate the holding of a reserve of short – term marketable securities, again a short term capital asset. The unpredictable and uncertain global market plays a vital role in working capital. Though the globalization of economy and free trading of products envisages the continuous availability of products but how much it’s cost effective and quality based varies concern to concerns.
Working capital refers to the funds invested in current assets, i.e., investment in stocks, sundry debtors, cash and other current assets. Current assets are essential to use fixed assets profitably. The term current assets refers to those assets which in the ordinary course of business can be converted into cash within one year without undergoing diminish in value and without disrupting the operations of the firm. The current assets are cash, marketable securities, accounts receivable and inventory. Current liabilities are those which are to be paid within a year out of the current assets or earnings of the concern. The current liabilities are accounts payable, bills payable, bank overdraft and outstanding expenses.
Concepts & Definitions of Working Capital: There are two concepts of working capital
1. Gross Working Capital: It represents the total current assets and is also referred to as circulating capital because current capital as current assets, are circulating in nature.
2. Net Working Capital: It is a measure of liquidity and it can be defined in two ways.
a. The most usually implied definition of net working capital is that it represents the difference between current assets and current liabilities. Some people also define it as excess of current assets over the current liabilities.
b. It is that portion of the firm’s current assets, which is financed by long term funds.
Nett working capital as a measure of liquidity is generally not very useful to compare the performance of different units due to difference in scales of operation, efficiency, and creditability in the market etc., between the different firms. However it is a very useful measure for internal control purposes. It can also be used to compare the liquidity position of the same unit over a period of time. This will help in maintaining the acceptable level of net working capital.
Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital.
A few key performance ratios of a working capital management system are the working capital ratio, inventory turnover and the collection ratio. Ratio analysis will lead management to identify areas of focus such as inventory management, cash management, accounts receivable and payable management.
Role of Finance Manager: The financial manager plays a vital role in management of working capital. The financial management of any business organization involves the three following vital functions:
1. Management of Long Term Assets
2. Management of Long Term Capital
3. Management of Short Term Assets and Liabilities
In most of the organizations the first & second one which refers to Capital Budgeting and Capital Structure respectively will be maintained and cope up with organization growth. The third one which refers to Working Capital Management requires more skills for sustaining and steady growth rate for any organization.
The working capital management includes decisions
i. How much stock/inventory to be hold
ii. How much cash/bank balance should be maintained?
iii. How much the firm should provide credit to its customers?
iv. How much the firm should enjoy credit from its suppliers?
v. What should be the composition of current assets?
vi. What should be the composition of current liabilities?
For e.g. a machine cannot be used without raw material. The investment on the purchase of raw material is identified as working capital. It is obvious that a certain amount of funds is always tied up in a raw material inventories, work in progress, finished goods, consumable stores, sundry debtors and day to day cash requirements. However the businessman also enjoys credit facilities from his suppliers who may supply raw material on credit. Similarly, a businessman may not pay immediately for various expenses. For instance, the labourers are pain only periodically. Therefore, a certain amount of funds is automatically available to finance the current assets requirements. However, the requirements for current assets are usually greater than the amount of funds payable through current liabilities. The satisfactory level of working capital is the main object of working capital management. Any organization which fails to maintain satisfactory level of working capital may be forced to bankruptcy. The current assets should always be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Thus the interaction between current assets and current liabilities is the main aim of working capital management.
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The business environment changed in a way that led to the need of BI:
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This article was submitted by CA Navneet Mehta.
Posted on June 8th, 2009 by Guest
Filed under: Business Intelligence, Emerging Trends, View Points & Perspective
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