Techniques for Finding Optimal Level of Working Capital

Working capital management techniques such as the intersection of carrying cost and shortage cost, working capital financing policy, cash budgeting, EOQ and JIT are applied to manage different components of working capital like cash, inventories, debtors, financing of working capital etc. These effective techniques mainly manage different components of current assets.

Working capital management techniques

Working capital management techniques are very effective tools in achieving the Objective of Working Capital Management. Working capital is the difference current assets and current liabilities of a business. A major focus is on current assets because current liabilities arise due to current assets only. Therefore, controlling the current assets can automatically control the current liabilities. Now, current assets include Inventories, Sundry Debtors or Receivables, Loans and Advances, Cash and Bank Balance.

All working capital management techniques attempt to find the optimum level of working capital because both excess and shortage of working capital involves a cost to the business. Excess working capital carries the ‘carrying cost’ or ‘interest cost’ on the capital lying unutilized. Shortage of working capital carries ‘shortage cost’ which include disturbance in production plan, loss in revenue etc. Finding the optimum level of working capital is the main goal or winning situation for any business manager.

There are certain techniques used for finding the optimum level of working capital or management of different items of working capital.

Intersection of Carrying Cost and Shortage Cost

One of the important methods of finding the optimum level of working capital is the point of intersection of carrying cost and shortage cost in a graphical representation. The total of carrying and shortage cost is minimum at this point.

Intersection of Carrying Cost and Shortage Cost

Here, the levels of current assets are optimum at the point where the shortage and carrying costs are meeting or intersecting. At this point, the total cost, as we can see, is minimum and this is why that level of current assets is considered to be optimal.

Working Capital Financing Policy

Working capital can be divided into two viz. Permanent and Temporary. Permanent working capital is the level of working capital which is always required and maintained. Temporary working capital is the part of working capital which keeps on fluctuating. It is high in good seasons and low in bad seasons. There are two types of financing available. They are long-term financing and short-term financing. Three strategies are possible with respect to the financing of working capital. Efficient financing of working capital reduces carrying a cost of capital.

  1. Long term financing is used for both permanent and temporary WC.
  2. Long term financing is used for permanent and some part of temporary WC. Remaining part of temporary WC is financed through short-term financing as and when required.
  3. Long term financing is used for permanent and short-term financing for temporary WC.

These strategies should be chosen so as to match the maturity of the source of finance with the maturity of the asset.

Cash Budgeting

Cash budgeting is another important technique for working capital management which helps to keep an optimum level of cash in the business. Cash budgeting involves estimating the requirements of cash by estimating all the fore coming receipts and payments. For effective management, a balance is needed between both excess and shortage of cash. It is because both ends are costly. Speeding up of collection and getting relaxed credit terms from the creditors can reduce the cash requirements.

Inventory Management

Inventory is an important component of working capital or current assets. An optimum level of inventory can save on costs heavily.

EOQ

Economic Order Quantity (EOQ) model is a famous model for managing the inventories. It helps the inventory manager know how to find the right quantity that should be ordered considering other factors like cost of ordering, carrying costs, purchase price and annual sales. The formula used for finding EOQ is as follows:

EOQ = ?{ (2 * A * O) / (P * C)}

A – Annual Sales

O – Cost per Order

P – Purchase price per unit

C – Carrying Cost

Just-in-Time

Just-in-time is another very important technique which brought about the paradigm shift in the management of inventories. It did not reduce the cost of inventory but it abolished it completely. Just-in-time means acquiring raw material or manufacturing product at the time when it is required by the customer. This strategy is very difficult to implement but if implemented can bring down inventory cost to minimum levels.

These are some important techniques discussed here. They are very effective in managing working capital. Managing working capital means managing current assets. Current assets like cash can be managed using cash budgeting; inventory can manage using inventory techniques like EOQ and JIT. Debtors and financing of working capital can be managed using appropriate sources of finance.

Last updated on : March 30th, 2018

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