Every organization requires funds or capital right from the inception, till the company is wound up. The requirement of capital at the inception of the company is mostly in fixed form; fixed capital is also called as permanent capital, this capital is raised by the promoters of the company at the inception either in the form of equity share capital, preference share capital, long-term borrowings are arranged in the form of debentures (secured or unsecured), public deposits. Each and every form of capital raised by the company attracts some kind of cost. After the inception of the company, when the company is established and operations begin, in order to keep the wheels of the business turning the capital that is required, is termed as circulating, revolving, or working capital. Excess of current assets over current liabilities is termed as Working Capital.
Current assets comprise of Inventory or stock of goods, inventory is one of the important components of current assets, and the majority of the researchers have time in again explained, verified, and validated the importance of inventory and also its effective management. The next component of working capital is debtors, it is also inclusive of bills receivable. When the company sells goods to its customers if the sale is purely in cash, it is termed as cash sales, in the case of cash sales, there is the immediate realization of money invested in the production and ensures greater liquidity and increased profitability. But in the present scenario, unless and until it is inherent in the nature of the business, credit sales are inevitable, credit sales are the sales made by the company on a credit basis, in the sense that, the company sells the goods to the customers but does not realise cash at the time of sale. The next component of working capital is cash in hand, and at the bank, this is the amount that is retained by the firm with them in order to meet day-to-day immediate expenses. This requirement is exactly not known, therefore, it is the practice of the company to maintain a minimum balance of cash to meet their expenses in a balanced form.
The components of current liabilities are creditors also termed as payables, this further includes bills payables. It is the amount that the firm may have to pay for the material, stock or goods bought by the company on credit basis. Receivables is where the goods are sold on credit, Payables are where the goods are bought on credit. It is the firm that purchases goods on a credit basis, the individual or firm selling goods is termed as a Creditor. The other types of current liabilities are Bank Overdrafts, Provisions, Short-Term Deposits, etc.
Objectives of Working Capital Management
The most important objectives of working capital management are liquidity and profitability, it is an ardent duty of the finance manager to wisely trade off between the two as they are mutually exclusive, in the sense that, if firm wishes to maintain liquidity it may have to forego profitability and if the firm wishes to maintain profitability, it may have to forego liquidity, as mentioned earlier, the managers of finance should be able to arrive at a proper balance between the two.
There are many challenges a firm encounters in the course of arriving at a proper balance between the two, the irregular supply of material, seasonal supply of material, fluctuating bank rates and interest rates, policies of the company, regulatory requirements, changing taxes and duties, unreliable supply chain, climatic conditions, transport strike, labour strike, lockouts, natural calamities, industrial accidents, economic and political conditions, fluctuation in foreign exchange, rise or fall in the value of rupee, etc., all these factors directly or indirectly contribute or hamper the objective of maintaining liquidity or profitability.
Need for Working Capital Management
If finance is the lifeblood of the business, working capital keeps the blood circulating, it is for this reason that working capital is also referred to as „Circulating Capital‟. The requirement of working capital varies from industry to industry, firm to firm, and department to department within the firm. The requirement of working capital is lesser in case of a capital-intensive industry than when compared to the labour-intensive industry. The below-mentioned points highlight the need for working capital:
- Working capital is required to run the day to day business activities
- The requirement of working capital differs from firm to firm, industry to industry and department to department.
- Firms aim at maximizing the wealth of the shareholders, for this they are required to earn sufficient funds from their operations.
- Earning regular income requires constant sales activities.
- Huge investment is required to be made in current assets in order to increase the sales
Methods of Estimating Working Capital requirement
One of the tedious jobs of any finance department is to estimate and analyse the exact requirement of working capital. The requirement of working capital as mentioned earlier varies from firm to firm, Industry to Industry, department to department, and from period to period. The majority of the decisions taken by the firm are on the basis of their experience in the business over the years, or it could be on the basis of suggestions given by the financial analysts, or it could be on the basis of the company‘s policies and many more factors, but it is very important that the finance manager decides on the requirement of working capital on the basis of a few methods that are commonly practiced by the firms in estimating the requirement of working capital.
The three most commonly followed methods of estimating the requirement of working capital are mentioned below:
A. Percentage of Sales Method:
The theoretical assumption is that the requirement of working capital largely depends on its sales. So the most commonly observed conventional method of estimating working capital is on the basis of the ‘Percentage of Sales Method‘. The requirement of working capital is decided on the basis of sales. For instance, if sales are Rs. 100, and the working capital over 5 years was around Rs. 40 (approximately). Then, the percentage of sales method will be WC ÷ Sales x 100 i.e., 40%, every year, till any improvement or change is witnessed in the business the working capital will be maintained at 40% of Sales as per our example.
B. Regression Method
This is one of the highly used statistical estimation tools in measuring the requirement of working capital. This method explains the possible association of sales revenue and working capital with the help of a statistical equation i.e.
Working Capital = α +β x Sales revenue
The β in the above-mentioned equation represents the rate of change in working capital with every unit increase/decrease in sales revenue. The ‘α‘ value signifies the point in the graph, where the regression line depicting the impact and the working capital axis meet in the graph.
C. Operating Cycle Method
This method is commonly followed as it is simple to understand and easier to calculate with the available information. The operating cycle indicates the time taken by cash to convert itself back into cash. The longer the operating cycle larger will be the requirement for working capital. The smaller the operating cycle, the lesser will be the requirement for working capital.
The requirement of working capital as per this method is calculated with the help of the below-mentioned formula:
Estimated WC= Estimated Cost of Goods Sold x (Days in Operating Cycle ÷ 365 days) + Available cash and bank balance
This formula helps in estimating not only the requirement of working capital but also estimating days in an operating cycle or the cost of goods sold.
For citing this article use:
- Anjum, R. (2018). An Empirical Study of working Capital Management Practices and its Impact on Profitablity of Corporates in India.