What is Working Capital?
Working capital is the capital used for running day-to-day operations of a business. Commonly the gap between the current assets and current liabilities is called the working capital. Current assets include cash and bank balance, accounts receivable, inventory or any other assets which can be liquidated within a period of 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. 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 net working 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 assets which are not used for the core operations of the business and on the similar grounds non-operating current liabilities are those liabilities which are not related to the core operations of the business. 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 the shipping of product 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 which is affecting current assets and current liabilities. For Example with payment of Wages, Salary, purchase of Fixed Assets, repayment of loan etc. working capital requirement increases. On the other hand, when you sale goods on profit, sale of any long term security etc. working capital requirement decreases. But, there is a certain level of WC which 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
When you reduce permanent working capital from the NOWC, you get temporary working capital. This is that working capital which keeps fluctuating. Normally, the fluctuations could be due to seasonal demands, special order, any special event etc.
Permanent and temporary working capital is nothing but the bifurcation of net operating working capital based on 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 time period. It is an approximate method to calculate working capital requirement. 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 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 above calculation assumption is made that annual expense of the company is evenly spread through out the year.
It can be used as performance indicators. Lower the days working capital better is the performance in terms of a firm’s ability to manage working capital. As quoted above, in some companies, this metric comes out as a negative figure also, 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 its management? Look at the excerpt from the book Financial Management by Brigham.
After reading this, you can dedicate the variation in DWC to a different operating environment of different industries. You will find huge variations within industries also. Just read following:
Hope, this will clearly make us realize the importance of 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 which has a following cash conversion cycle:
- Raw Material Holding Period (Raw Material Kept in stores department before issue 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 Average Payment Period for Raw Material. (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 which is close to around 3 months. The money that 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 of the 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 optimize 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, 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 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 as well as short-term finance. 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 so as to maximize a firm’s long-run profits. There are three types of working capital policies which firm can follow:
Relaxed Policy / Conservative policy
Relaxed policy is the 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
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 accompanied with this policy is the risk of breaking the operating cycle in times of emergencies, the risk of bankruptcy is high.
Moderate policy is the policy that sets and level between the relaxed and restricted policy. It is neither too relaxed and nor too lean and mean. 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 asset and risk of insolvency will be more in comparison to 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 financing policies. 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)
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 which would last for 10 years, should be financed by a 10 years loan, bond, debenture etc. On the other hand, inventory which would probably sell in 45 days should be financed by a 45-day bank loan. The baseline is that fixed assets and permanent working capital should be financed by long-term finances whereas temporary working capital should be financed by short-term or instantaneous financing options. This is a very idealistic policy which has certain unreal assumptions like the life of an asset is known exactly in advance and availability of highly flexible financing options in the market.
Relatively Aggressive Approach
The baseline of the relatively aggressive approach of financing is that fixed assets and a part of permanent working capital are financed by long-term finances whereas temporary working capital and remaining permanent working capital is financed by short-term or instantaneous financing options. Under an impression that short-term finance is a cheaper to long-term finances, some entrepreneur takes 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 the 10 years by a 1-year bank loan, it can face the problem of liquidity. In this case asset does not start generating return, however there is a requirement of repayment of loan. 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.
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 finances the remaining part of the temporary working capital. With this approach, there are rare chances of falling prey to bankruptcy issues.
In general terms always a company should follow moderate policy or it may follow conservative policy. Following aggressive policy is always very risky.