What is Working Capital?
By its definition Working Capital = Current Assets – Current Liabilities
But for Management purposes, significant Accounts under Current Assets and Current Liabilities are Inventory, Account Receivables and Account Payables. These are Accounts whose values and turnovers determine the Cash Conversion Cycle. Cash Conversion Cycle is the time taken between Cash Outflows for purchasing Inventory to the time when Cash Inflows are materialized by selling that Inventory. For a given level of Sales, Companies strive for minimizing this cycle time, to achieve greater Profitability and higher Return on Assets (ROA). But managing Working Capital is not just trying to minimize CCC (Cash Conversion Cycle), there is more to that.
What is the need for managing Working Capital?
The need for managing Working Capital arises from the fact that Sales are usually Volatile and Unpredictable. This volatility in Sales gets transferred spontaneously to Current Accounts like Inventory, Account Payables, Account Receivables, Accrued Wages and Accrued Taxes.
For example, when Sales increase:
· More Inventory is bought to support increasing Sales. Inventory Account goes up and so does Account Payables.
· Additional labor is employed to sustain increased production activity and hence Accrued Wages go up.
· With additional income from Operations, Accrued Taxes go up.
· And with increased Sales, Account Receivables go up.
With this spontaneous increase in your Current Assets, you need to plan for additional funds to Finance these swollen Assets. Yes, part of this is financed automatically by your suppliers thru Account Payables, but for the remaining funds and duration, financing needs to be managed. And your Working Capital Management plan needs to take care of both, increasing as well as decreasing Sales.
You need to consider a mix of the following two Strategies to come up with a Plan:
By its definition Working Capital = Current Assets – Current Liabilities
But for Management purposes, significant Accounts under Current Assets and Current Liabilities are Inventory, Account Receivables and Account Payables. These are Accounts whose values and turnovers determine the Cash Conversion Cycle. Cash Conversion Cycle is the time taken between Cash Outflows for purchasing Inventory to the time when Cash Inflows are materialized by selling that Inventory. For a given level of Sales, Companies strive for minimizing this cycle time, to achieve greater Profitability and higher Return on Assets (ROA). But managing Working Capital is not just trying to minimize CCC (Cash Conversion Cycle), there is more to that.
What is the need for managing Working Capital?
The need for managing Working Capital arises from the fact that Sales are usually Volatile and Unpredictable. This volatility in Sales gets transferred spontaneously to Current Accounts like Inventory, Account Payables, Account Receivables, Accrued Wages and Accrued Taxes.
For example, when Sales increase:
· More Inventory is bought to support increasing Sales. Inventory Account goes up and so does Account Payables.
· Additional labor is employed to sustain increased production activity and hence Accrued Wages go up.
· With additional income from Operations, Accrued Taxes go up.
· And with increased Sales, Account Receivables go up.
With this spontaneous increase in your Current Assets, you need to plan for additional funds to Finance these swollen Assets. Yes, part of this is financed automatically by your suppliers thru Account Payables, but for the remaining funds and duration, financing needs to be managed. And your Working Capital Management plan needs to take care of both, increasing as well as decreasing Sales.
You need to consider a mix of the following two Strategies to come up with a Plan:
1. Investment Strategy
2. Financing Strategy
1. Investment Strategy: This is to plan how much you want to Invest in your Current Asset Accounts. Basically you are planning on the size of your Cash Conversion Cycle (CCC), we talked earlier. Based upon your top level Business Strategy and your Industry Environment, you could either go for a Restrictive Investment Strategy or a Relaxed Investment Strategy.
a) Restrictive Investment Strategy: In a Restrictive Strategy, you plan to minimize your CCC by minimizing your levels of Inventory, following a tight Credit Policy for Receivables and plan on using Supplier Credit for its full allowed term. Your gain is lower investment in Current Assets, higher Profitability and Higher ROI. But your risk is missing out on potential upward swings in Sales due to lower inventory and tighter customer credit.
b) Relaxed Investment Strategy: In this strategy, your Investment in Current Assets is higher by maintaining higher Inventory Levels and a more relaxed Customer Credit Policy. You may be having higher gross profits in your business and your higher investment in Current Assets is well compensated by your Potential Increased Sales.
2. Financing Strategy: This strategy considers how you want to finance your Current Assets. You have options of financing them with either Long Term or Short Term loans or with a mixed of both. In general, Short Term loans are less costly (as normally, yield curve is upward sloping, meaning, short term interest rates are usually lower than long term interest rates). But disadvantage with Short Term Loans is higher Interest Rate Risk. Meaning, if you need financing now and current market rates are high, you have no option but to take it with higher rates. Also, with short term loans, there is a risk of their availability. For example, under recessionary conditions, as in present times, it may not be available to you, or, your credit ratings have changed and it is more costly now, even though it is available.
With using Long Term Loans to finance your Current Assets, you may have locked down a fixed rate loan for a long term, or may have hedged your Floating loan for Fixed and have thus eliminated any Interest Rate risks. But, you are usually paying a higher rate of Interest. Also, as your Current Asset Accounts are spontaneously fluctuating with Sales, you will have excess Liquidity when your Sales are low. This will further decrease your profitability.
Now, before going further into which Financing Strategy could suit you, lets’ understand how Current Assets could be further sub-classified.
From your previous historical Sales, you could establish a Minimum Sales figure that your business has. And, from these minimum Sales, you could establish your minimum Current Assets required to support those. This sub-division of Current Assets forms ‘Permanent Current Assets’ part of your Current Assets. The remaining portion is classified as ‘Fluctuating Current Assets’.
Now there are broadly three ways, you could choose to plan your Financing:
a) Maturity Matching: In this, you plan to use Long Term Loans for financing your Fixed Assets and Permanent Current Assets. And, Short Term Loans to finance your Fluctuating Current Assets.
b) Conservative Policy: Under this, you plan to use Long Term Loans for financing your Fixed Assets, Permanent Current Assets and also a portion of your Fluctuating Current Assets. This portion is usually the average of your historical fluctuations. And, only the remaining part of Fluctuating Current Assets is financed using Short Term debts.
c) Aggressive Policy: Under this, you plan to use Long Term Loans to finance Fixed Assets and only a portion of Permanent Current Assets. Remaining portion of Permanent Current Assets and all of Fluctuating Current Assets are financed using Short Term Loans.
Now, based on your Sales Volatility, Line of Business, Industry and Current Economy, you could have various mixes of Investment and Financing Strategies to come up with your Working Capital Management Policy.
To summarize, establishing a Working Capital Management policy needs co-ordination from multiple departments. With Operations to optimize Inventory, with Purchasing for getting maximum Supplier Credit, with Sales for optimizing Customer Credit and with Treasury for optimally Financing it. And more importantly, this needs to cater for fluctuating Sales, external environment and also be in line with overall Business Strategy.
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