18-12-2012, 03:04 PM
Working capital management
Working capital.docx (Size: 637.47 KB / Downloads: 72)
Introduction
In a perfect world, there would be no necessity for current assets and liabilities because there would be no uncertainty, no transaction costs, information search costs, scheduling costs, or production and technology constraints. The unit cost of production would not vary with the quantity produced. Borrowing and lending rates shall be same. Capital, labour, and product market shall be perfectly competitive and would reflect all available information, thus in such an environment, there would be no advantage for investing in short term assets.
However the world we live is not perfect. It is characterized by considerable amount of uncertainty regarding the demand, market price, quality and availability of own products and those of suppliers. There are transaction costs for purchasing or selling goods or securities. Information is costly to obtain and is not equally distributed. there are spreads between the borrowings and lending rates for investments and finanancings of equal risks. Similarly each organization is faced with its own limits on the production capacity and technology it can employ there are fixed as well as variable costs associated with production goods. In other words, the markets in which real firm operated are not perfectly competitive.
Aggressive financing policy: A firm following an aggressive financing policy will use more of bank borrowings and public deposits and less of long-term sources of finance for financing its current assets. Such a policy will be useful for companies that have a fluctuating need for current assets because usually the bank borrowings are geared to move in tandem with the fluctuating level of current assets so that the total interest charge for the company is likely to be low. But an aggressive financing policy involves higher risk of “technical insolvency.”
Hence, depending upon the attitude of management towards risk and keeping in view the constraints imposed by banking sector with respect to short-term credit, the firm should choose the appropriate financing policy.
STATIC VIEW OF WORKING CAPITAL
As per the static view, working capital can be defined in two ways:
Gross working capital: It is equal to the total current assets (including loans and advances).
Net working capital: It is the difference between current assets and current liabilities (including provisions). It can be also described as that part of a firm’s current assets which is financed with the help of long-term funds. The net working capital of a firm helps in comparing the liquidity of the same firm over a period of time. The liquidity of a firm can be defined as the ability of the firm to satisfy short-term obligations as they become due.
The static view of working capital lays more emphasis on the level of current assets compared to the level of current liabilities.
Drawbacks of static view of working capital:
The static view of working capital has the following drawbacks:
1. The working capital under this view is computed using the data given in the balance sheet that is static in nature and fails to reflect the dynamic nature of working capital that is crucial in decision making.
2. The net working capital which is computed as the difference between current assets and current liabilities does not reflect the correct amount of working capital due to the following reasons:
-Short-term bank borrowings that are used for financing current assets are shown separately under the heading of secured loans and not as a part of current liabilities.
-Short-term Public deposits utilized for financing current assets are shown under the category of unsecured loans and are not included in current liabilities. Short-term marketable securities that are held for the purpose of providing liquidity to the firm are shown under the heading of investments and are not included in the current assets.
DYNAMIC VIEW OF WORKING CAPITAL
The dynamic view defines working capital as the amount of capital required for the smooth and uninterrupted functioning of the normal business operations of the firm encompassing various activities commencing with the procurement of raw materials, conversion of raw materials into finished product for sale, creation of accounts receivable on account of goods sold on credit and finally realization of profits from sales and cash from accounts receivable. As per this definition of working capital, the following activities would come under the purview of working capital management
WORKING CAPITAL
In simple words working capital is the excess of current Assets over current liabilities. Working capital has ordinarily been defined as the excess of current assets over current liabilities. Working capital is the heart of the business. If it is weak business cannot proper and survives. Sit is therefore said the fate of large scale investment in fixed assets is often determined by a relatively small amount of current assets. As the working capital is important to the company is important to keep adequate working capital with the company. Cash is the lifeline of company. If this lifeline deteriorates so des the companies ability to fund operation, reinvest do meet capital requitrents and payment. Understanding Company’s cash flow health is essential to making investment decision. A good way to judge a company’s cash flow prospects is to look at its working capital management. The company must have adequate working capital as much as needed by the company. It should neither be excessive or nor inadequate. Excessive working capital cuisses for idle funds laying with the firm without earning any profit, where as inadequate working capital shows the company doesn’t have sufficient funds for financing its daily needs working capital management involves study of the relationship between firm’s current assets and current liabilities. The goal of working capital management is to ensure that a firm is able to continue its operation. And that is has sufficient ability to satisfy both maturing short term debt and upcoming operational expenses. The better a company managers its working capital, the less the company needs to borrow. Even companies with cash surpluses need to manage working capital to ensure the those surpluses are invested in ways that will generate suitable returns for investors.