LOS 1

Introduction to the Management

of Working Capital
Learning Outcome Statement (LOS)

 Experience shows that the inadequate planning and control of working

capital is one of the more common causes of business failure. And yet
the management of working capital is a neglected subject which has
been all too little investigated or written about.

 Major advances have been made in developing new techniques for

long-term investment and financial decisions; but far less attention has
been paid to the short-term capital requirement.

 This chapter demonstrates some of the ways of analyzing the subject

and ends with a discussion of the need for an adequate provision of
working capital.
Introduction

 The financial management of business firms involves three functions:

 The management of long-term assets (capital budgeting)

 The management of long-term capital (capital structure)

 The management of short-term assets and liabilities (working

capital management)
What is Working Capital?
 Working capital refers to the cash a business requires for day-to-day
operations, or, more specifically, for financing the conversion of raw
materials into finished goods, which the company sells for payment.

 Among the most important items of working capital are levels of

inventory, accounts receivable, and accounts payable.

 The working capital is calculated as: Working Capital = Current

Assets – Current Liabilities.

 Positive working capital means that the company is able to pay

off its short-term liabilities. Negative working capital means that a
company currently is unable to meet its short-term liabilities with its
current assets.
What is Working Capital?

 Current Assets include:

 stock or inventory (raw materials + work-in progress + finished goods)

 debtors (unpaid bills for which the profit has already been realized)

 trade credit (from suppliers)

 cash in hand

 short-term securities

 Current Liabilities include:

 monies owing to trade creditors (mainly for raw materials)

 bank overdrafts

 other short-term loans

 outstanding tax, dividend and interest obligations

What is Working Capital?
 If a company's current assets do not exceed its current liabilities, then
it may run into trouble paying back creditors in the short term. The
worst-case scenario is bankruptcy.

 A declining working capital ratio over a longer time period could also
be a red flag that warrants further analysis.

 For example, it could be that the company's sales volumes are

decreasing, and as a result, its accounts receivables number
continues to get smaller and smaller.
What is Working Capital?

 Working capital is a measure of a company's efficiency and its short-

term financial health.

 For example, if a company is not operating in the most efficient

manner (slow A/R collection), it will show up as an increase in the
working capital. This can be seen by comparing the working capital
from one period to another; slow collection may signal an underlying
problem in the company's operations.
What is Working Capital Management?

 Working capital management is a managerial accounting strategy

focusing on maintaining efficient levels of both components of
working capital (current assets and current liabilities) in respect to
each other.

 Working capital management ensures a company has sufficient cash

flow in order to meet its short-term debt obligations and operating
expenses.

 A few key performance ratios of a WCM system are: working

capital ratio, inventory turnover and the collection ratio.
These ratio analysis will lead management to identify areas of focus
such as cash management, accounts receivable management,
inventory management, and account payable management.
What is Working Capital Management?

 The management of working capital is concerned with the management

of the assets and liabilities in the top half of the balance sheet.

 We will analyze decisions such as:

 How should the firm manage its cash?

 To whom should the firm grant credit?
 How much inventory should the firm keep?
 What should be the composition of the firm’s current debt?
Objectives of Working Capital Management

 The two main aims to be satisfied by the working capital manager are
profitability and liquidity.

 Investments, in current as well as long-term assets, should be

undertaken if they will offer the most satisfactory returns to
shareholders – measured by net present values discounted at the cost
of capital.

 The goal of liquidity is designed to ensure that the firm can satisfy its
financial obligations and continue as a going concern.
Objectives of Working Capital Management

 The two goals of profitability and liquidity frequently conflict with one
another. Attempts to produce the maximum profitability out of the
various elements of the working capital can create severe liquidity
problems. At the same time, over-concentration on liquidity can water
down profits.

 A major function of decision making for working capital is the

management of the various working capital accounts with regard to
the firm’s level of liquidity: NOT TOO MUCH LIQUIDITY AND NOT
TOO LITTLE LIQUIDITY.

 Management means establishing the best possible trade-off between

the profitability of the net current assets employed and the ability to
pay current liabilities as they fall due. This latter implies a clearly
defined risk policy to determine the required liquidity level.
Importance of Working Capital Management

 There would be no need of holding cash for working capital other

than for the initial costs, because it could be possible to make the
payment from every receipt of sales.

 Likewise, there would also be no need for receivables and payables if

customers pay cash immediately and the firm would also make its
payments promptly.

 However, problems of working capital exist because these ideal

assumptions are never realistic and therefore working capital levels
make a significant part of a firm’s investment in assets and these
assets have to be financed implying that investments may have
benefits as well as costs.
Importance of Working Capital Management

 Implementing an effective working capital management system is an

excellent way for many companies to improve their earnings.

 Working capital consists of a large portion of a firm’s total investment

in assets. It amounts usually to 40 percent in manufacturing
industries and 50% - 60% in retailing and wholesales (Moyer,
Mcguigan and Kretlow, 1995).

 By minimizing the amount of funds tied up in current assets, firms are

able to reduce financing costs and/or increase the funds available for
expansion.

 Therefore, the importance of efficient working capital management is

indisputable in business.
Importance of Working Capital Management

 By implementing best practices in working capital, companies can

strengthen strong cash flow levels, improve profitability, budgeting
and forecasting process, predictability and manageability of results,
heighten risk visibility and reduce reaction time.

 Scherr (1989) considering the importance of WC found that

managers spend much of their time in activities directly or indirectly
related to working capital investments and short-term debts. Survey
evidence shows that 60% of a financial manager’s time is spent on
decisions related to working capital management.

 The management of working capital plays an important role in

maintaining the financial health of the firm during the normal course
of business.
Importance of Working Capital Management

 Besides this basic and continuing reason for the importance of working
capital management to the firm, several developments in the late
1970s and early 1980s led to increasing concern for the management
of these accounts.

 For example, level of interest rates that climbed extremely high by

historic standards, caused the financing of investments to become
more costly. Deregulated money markets provided financial managers
with access to many instruments for short-term financing and
investment.

 Together, these developments kept corporate treasurers seeking new

and better ways of managing individual working capital accounts to
balance the firm’s overall liquidity position.
Managing Working Capital Crisis

 Present-day industrial organizations are confronted more and more

with a shortage of working capital with which to run their units at an
economical level of operation.

 With the ever increasing rate of inflation, associated with an increase

in the cost of capital and more demands for resources due to rapid
industrialization, with a consequent credit squeeze policy adopted by
the banks and financial institutions, the management of working
capital has assumed great significance recently.

 In many organizations the technology adopted may not be so

advanced, resulting in lower operational efficiency, uneconomical costs
and a longer manufacturing cycle time.
Managing Working Capital Crisis

 The working capital needs of an organization depend on a multitude of

factors, such as operating level, level of operational efficiency, service
level, inventory policies, book debt policies, etc.

 Financing is based on the extent of internal cash generation, the

availability of credit limits, minimum margin stipulations, the relative
cost effectiveness of different sources of financing, etc.

 All factors are time dependent and are dynamic in nature. To deal with
many interacting variables of a dynamic nature in an integrated
manner, cause and effect analysis using a system dynamics technique
could be of great assistance in formulating strategies for effectively
managing working capital to overcome the crisis.
Formulating Appropriate Strategies

 To tide the organization over the working capital crisis and to further
improve its financial position some short- and long-term strategies
need to be adopted.

 Short-term strategies should meet the immediate challenge of the

working capital crisis. However, the scope of such strategies may be
restricted.

 To manage working capital more effectively, long-term strategies may

have to be adopted to reduce the working capital needs of the
organization, to increase its level of operation and, consequently, to
generate more and more funds, to finance working capital
requirements.
Short-Term Strategies

 Gearing up book debt collection efforts by adopting more stringent

follow up methods, offering discount to the customers against prompt
payment.
 Restricting credit policy
 Operating more and more with customers‘ materials, thereby reducing
the inventory level
 Reducing the service level
 Slashing developmental expenditure over the short-term — cutting
back on its R&D budget, training and development budget or product
promotional expenditure, etc.
 Improving profitability through short-term measures like improving
capacity utilization through letting out facilities, exploiting demand by
subcontracting, negotiating with the bank for softer terms and higher
credit limits.
 Negotiating with the creditors like deferring payment to creditors,
converting the loan into equity, etc.
Long-Term Strategies

 Reducing the working capital needs

 Reducing the inventory holding requirement
 Improving product quality & then demanding restricted credit terms
 R&D efforts leading to improved operational efficiency
 Cost reduction through higher capacity utilization

 Improving capacity utilization

 Removing input constraints
 Plant modernization and improvement for higher plant availability
 Capacity expansion
 Quality control efforts
 Product promotion
Working Capital Management Practices in
Bangladesh

 There are a few studies on working capital management in Bangladesh

covering both public and private sectors including several multinational
companies (MNCs).

 Mohiuddin (1983) has conducted a study on cash budget and

concluded that effective cash budgeting minimizes the liquidity
problems.

 Islam and Rahman (1994) have identified the working capital trends of
some selected enterprises in Bangladesh.
Working Capital Management Practices in
Bangladesh

 Sayaduzzaman (2006) has conducted study on British American

Tobacco Bangladesh Company Ltd. and found that the working capital
management practices of the company is highly satisfactory due to
efficient management of inventory, debtors, cash balances and
working funds.

 Chowdhury and Amin (2007) has conducted a study on pharmaceutical

industry and concluded that pharmaceutical firms operated in
Bangladesh are efficiently deal with their liquidity preferences and
investment criteria and this is due to the competitive nature of this
industry.
Working Capital Management Practices in
Bangladesh

 The studies conducted in Bangladesh on working capital management

is either company specific (Islam and Rahman, 1994; Sayaduzzaman,
2006) or at best industry specific (Zaman, 1976; Zaman, 1991b;
Zaman, 1991c; Chowdhury and Amin, 2007).

 There is no such study of evaluating working capital management

performances of a large sample of manufacturing ventures in
Bangladesh.

 One such study has been conducted by Siddiquee and Khan (2009)
covering 83 companies (total 414 observations) from different sectors
enlisted with the Dhaka Stock Exchange (DSE) Ltd. during the
stipulated period of 2003-2007.
Working Capital Management Practices in
Bangladesh

 Another study on the working capital management practices,

commissioned by Siddiquee and Hossain (2009) covers a large sample
size of 243 manufacturing companies from different sectors.

 The sample includes companies from the sectors: Cement, Ceramics,

Engineering, Food and Allied, Fuel & Power, ICT, Jute, Leasing,
Leather, Miscellaneous, Paper & Packaging, Pharmaceuticals &
Chemicals, Services & Real Estate, and Textile.