What is Working Capital?
Working capital is the capital used for running the day-to-day operations of a business. The gap between the current assets and current liabilities is commonly called the working capital. Current assets include cash and bank balance, accounts receivable, inventory, or any other assets that can be liquidated within one year. Similarly, current liabilities are liabilities that are due for payment within a period of one year.
Various Definitions of Working Capital (WC)
There are many prevalent definitions of WC for different contexts and purposes. These are also known as the various types of working capital. Let us try and cover each of the definitions first:
- What is Working Capital?
- Various Definitions of Working Capital (WC)
- Days Working Capital (DWC)
- Why is Working Capital Important?
- Objective of Working Capital Management
- Working Capital Policy
- Working Capital Financing Policy
Gross Working Capital (GWC)
It refers to the Current Assets (CA) available with the business. It is called GWC because the contribution of Current Liabilities (CL) in reducing the overall working capital need is not considered here.
Net Working Capital (NWC)
When gross working capital is reduced by the amount of current liabilities available with the business, it is called net working capital. This is the most common definition represented by
NWC = CA – CL
Net Operating Working Capital (NOWC)
The concept of net operating working capital is similar to networking capital. The only difference is that it considers only the operating current liabilities and operating current assets for determining the net operating working capital.
NOWC = Operating CA – Operating CL
It raises a question in mind. What are non-operating current assets or liabilities, then? Non-operating current assets are those that are not used for the business’s core operations. And on similar grounds, non-operating current liabilities are those liabilities that are not related to the business’s core operations. Non-operating current assets include marketable securities, cash in excess of operating requirements, and other current investments not used for the core operations.
Positive and Negative Working Capital
Positive working capital is when NWC or NOWC is positive. When they are negative, it is negative working capital. Companies like Amazon enjoy negative working capital because of cash sales, where buyers pay money even before shipping products, and there is a time gap in making payments to suppliers.
Permanent Working Capital
We know that the WC need of a business fluctuates with a transaction that affects current assets and current liabilities. For Example, with payment of Wages, Salary, purchase of Fixed Assets, repayment of loans, etc., the working capital requirement increases. On the other hand, when you sale goods on profit, the sale of any long-term security, etc., the working capital requirement decreases. But, there is a certain level of WC that always keeps invested in the business. The level of working capital never goes below this level. So this level of working capital is called the permanent (or fixed) working capital.
Temporary Working Capital
You get temporary working capital when you reduce permanent working capital from the NOWC. This is that working capital that keeps fluctuating. Normally, the fluctuations could be due to seasonal demands, special orders, any special event, etc.
Permanent and temporary working capital is nothing but the bifurcation of net operating working capital based on a fluctuation. The primary reason to bifurcate is to achieve financing efficiencies. Like, permanent working capital needs can be addressed with long-term financing options, and on the contrary temporary WC is addressed with short-term finances.
Days Working Capital (DWC)
Day’s working capital is a measurement of working capital requirement based on the time period. It is an approximate method to calculate the working capital requirements. First of all Working Capital Cycle is calculated as under:-
= Raw Material Holding Period + Working Capital Holding Period + Finished Goods Holding Period + Average Collection Period – Average Payment Period.
It indicates that in how many days Cash invested in Raw Material is received back by the company in the form of collection from Debtors. Based on Working Capital Cycle, Working Capital Requirement is calculated as under:-
Annual Expense of the company / 365 Days * Working Capital Cycle.
In the above calculation, the assumption is made that the annual expense of the company is evenly spread throughout the year.
It can be used as a performance indicator. Lowering the days working capital better is the performance in terms of a firm’s ability to manage working capital. As quoted above, this metric comes out as a negative figure in some companies, like Amazon.
Why is Working Capital Important?
Why is working capital a very talked-about term? And why do organizations throw a lot of importance to their management? Look at the excerpt from the book Financial Management by Brigham.
After reading this, you can dedicate the variation in DWC to different operating environments of different industries. You will find huge variations within industries also. Just read the following:
I hope this will make us realize the importance of the management of working capital.
Objective of Working Capital Management
There are 3 primary objectives of Working Capital Management, viz.
Smooth Operating Cycle
Let’s take an example of a manufacturing company that has the following cash conversion cycle:
- Raw Material Holding Period (Raw Material Kept in stores department before issuing for production) (30 Days)
- Working In Progress Holding Period (Production Cycle) (40 Days)
- Finished Good Holding Period (Finished Goods kept in go down) (30 Days)
- Average Collection Period (Credit Period allowed to customers) (20 Days)
This time period is reduced by the Average Payment Period for Raw Materials. (Average Payment Period)
Working Capital Cycle may vary from industry to industry. Take any industry, but the objective would always be to keep this cash conversion cycle as smooth as possible. The bottleneck in any of the activities would break the business supply chain and increase the cycle.
Optimize Investment in Working Capital
The investment in WC starts from the first activity of buying raw material, and the funds become free only after the customer makes the payment. We saw that the cash conversion cycle in the above example was 100 days, close to around 3 months. The money you have borrowed for the smooth running of the operating cycle carries interest cost, or you may have your own funds, then it has an opportunity cost. Any delay in any activities would be costly to the business and directly attack the profit margins. There is a great potential for optimizing each activity in the operating cycle and consequently optimizing the investment in WC.
For example, techniques like ‘Just In Time’ can help reduce the time of holding raw materials, efficient ‘Production Planning’ can reduce the overall production time, and using inventory management techniques like EOQ can also optimize the amount of capital investment in stock, effective cash management. There are many more such techniques.
Minimize Cost of Working Capital Financing
There are many ways of financing the WC needs. It may be through long-term financing options like equities, long-term debt, etc. One can take the help of short-term financing options like WC loans, factoring, cash credit, letter of credit, etc. The third is to have a combination of both long and short-term finance. The objective of Working Capital Management also includes balancing of carrying cost of working capital.
Working Capital Policy
Working Capital management is nothing but managing the levels of current assets to maximize a firm’s long-run profits. There are three types of working capital policies that firms can follow:
Relaxed Policy / Conservative policy
A relaxed policy is one where the level of current assets is kept at a very high level. The benefit of this policy is that it maintains a very smooth operating cycle, no risk of bankruptcy, etc. The disadvantages are lower asset turnovers and, thereby, low ROI.
Restricted Policy / Aggressive policy
The restrictive policy is the opposite of Relax or Conservative policy, where the level of current assets is kept at the minimum possible level. The benefit of this policy is that it maintains very high asset turnover ratios and achieves higher ROI as well. The disadvantages of this policy are the risk of breaking the operating cycle in times of emergencies and the high risk of bankruptcy.
The moderate policy is the policy that sets and levels between the relaxed and restricted policy. It is neither too relaxed nor too lean and means. For this policy, liquidity and working capital will be more, return on asset, and risk of insolvency will be less in comparison to Aggressive policy. For this policy, liquidity and working capital will be less, return on assets, and risk of insolvency will be more than conservative policy.
Working Capital Financing Policy
Just above this, we learned how to manage the level of WC. Now, when we are clear on what will be the level of WC, it is time to decide how we will fulfill the working capital financing needs. There are three most prevalent working capital management strategies. These are based on the concept of permanent and temporary WC being financed by long-term and short-term financing options respectively.
Moderate Approach (Maturity Matching)
The maturity matching approach of working capital financing believes that the maturity of the current asset should match with the maturity of its financing option. Like equipment that would last for 10 years, it should be financed by a 10 years loan, bond, debenture, etc. On the other hand, inventory that would probably sell in 45 days should be financed by a 45-day bank loan. The baseline is that long-term finances should finance fixed assets and permanent working capital. In contrast, temporary working capital should be financed by short-term or instantaneous financing options. This is a very idealistic policy with certain unreal assumptions like the life of an asset known exactly in advance and the availability of highly flexible financing options in the market.
Relatively Aggressive Approach
The baseline of the relatively aggressive approach of financing is that long-term finances finance fixed assets and a part of permanent working capital. In contrast, temporary working capital and remaining permanent working capital are financed by short-term or instantaneous financing options. Under the impression that short-term finance is cheaper than long-term finances, some entrepreneur takes the risk of financing a part of fixed assets with short-term financing to achieve improved ROI. When a firm finances an equipment having a life of 10 years by a 1-year bank loan, it can face the problem of liquidity. In this case, the asset does not start generating a return. However, there is a requirement for repayment of loans. It is possible to see turbulent times in 10 years period when the business is in credit problems, and bank loan is not renewed. At this time, the business may have to face bankruptcy.
A Conservative approach is a risk-free approach for financing working capital. The baseline of this approach is that long-term sources of funds finance fixed assets, permanent working capital, and a part of temporary working capital, and short-term sources of funds finance the remaining part of the temporary working capital. There are rare chances of falling prey to bankruptcy issues with this approach.
In general terms, always a company should follow a moderate policy, or it may follow a conservative policy. Following aggressive policy is always very risky.