Working Capital Management (WCM): Everything You Need to Know

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By: Site Engineer, Staff

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The primary purpose of working capital management is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt issues.

Working capital management refers to a company’s managerial accounting strategy designed to monitor and utilize the two components of working capital, current assets, and current liabilities, to ensure the most financially efficient operation of the company.

The total cost of a project consists of two distinct parts:

(a)        Fixed Capital, and

(b)        Working Capital.

For estimating fixed capital requirement the cost of the machinery and equipment are taken into consideration based on current quotations for each physical units from reputable companies. However, the estimation of working capital requirements is not that easy as the components of working capital involve financial flows in the current operation of the business. Because of technical specifications, while fixed capital is estimated with a high degree of accuracy, the same care and attention are often not bestowed in calculating the working capital requirements.

Definition of Working Capital

Working Capital represents the money that is required for the purchase of raw materials payment of salaries wages and other expenses and for financing the interval between the date of supply of goods and the date of receipt of payment for the same.

The term working capital may be viewed either as “gross” or “net” working capital. Networking capital represents the amount that is aimed at deducting current liabilities from current assets. Therefore, the networking capital represents the liquid surplus and forms the margin against maturing obligations of the business. For determining networking capital correctly, accurate classification of assets and liabilities into current and noncurrent assets and liabilities would be a crucial factor.

The utilization of working capital involves a cyclical process. The cycle starts with cash, purchases of raw materials which becomes work-in-progress in the next stage and finished goods in the subsequent stage. When finished goods are sold, debts are created and when collected, cash flows back into the business and again back to the stage of few materials. Then the cycle process is repeated. According to the American Institute of Certified Public Accountant (AICPA), “the average time intervening between the acquisition of materials or services entering this process and the final cash realization constitutes an operating cycle”.

The concept of operating cycle as opposed to a rule of thumb in estimating working capital is based on the tested assumption that:

  • As the process of utilization of working capital is cyclical, the estimation of working capital should also be based on the operating cycle.
  • Each industry has its peculiar characteristics. The assessment of working capital according to the operating cycle considers these characteristics.
  • There is a functional relationship between the amount of working capital required and the period of the total of different stages of the operating cycle.

Importance of Working Capital

There are several reasons why estimates of working capital should be done carefully and meticulously. A recent survey of small-scale manufacturing companies reveals that capital assets form about 70 percent of the total assets. This clearly shows what would be the serious consequences and financial embarrassment if working capital is not estimated correctly. Working capital requirements vary with the level of sales volume. It is, therefore, necessary that adequate working capital is provided in advance to meet the anticipated level of sales.

Factors Affecting Working Capital Requirements

Largely the length of the operating cycle and the rate of flow of costs determine the working capital requirements within the operating cycle. The rate of flow of a cost, in turn, depends on the volume of production and sales and the costs associated with such production or sales.

Each of these is also influenced by several factors such as the followings:

  • Government policies relating to taxation.
  • Nature of industry and length of the period of the operating cycle. The speed of completion of the cycle depends upon the nature of the industry. Generally, the cycle is faster in the consumer industry than in the industrial goods industry.
  • Seasonal nature of an industry. For example, the fruit and canning industry requires the maximum amount of capital before the busy season commences and the least amount in the working season itself.
  • Where scarce of imported materials are concerned, a higher volume of working capital is required as the materials have to be stocked over a long period.
  • Credit practice. The longer the duration of the credit to the customer, the greater will be the number of receivables and hence the need for more working capital. Since the extent of credit that is available to the customers is dependent upon the competitive nature of an industry, competition in the industry may also be said to be a determining factor in the assessment of working capital. Working capital requirements are also influenced by company policies such as those relating to depreciation dividends expansion etc.
  • Similarly, the terms and conditions of purchase also influence the requirements of working capital.

Adequacy of Working Capital

Many small businesses do not have sufficient working capital while only a few may have more than enough.

The causes of inadequate and the consequences of excess working capital are as follows.

Causes of Inadequate Working Capital

  • Reduction in values of inventories
  • Excessive bad debts
  • Payment of unearned dividends
  • Operating losses
  • Diversion of current assets for financing fixed assets
  • Increase in volume of business and the consequent need for additional current assets without adequate material resources
  • Loss due to unforeseen circumstances

Consequences of Inadequate Working Capital

  • It can result in business failure.
  • It can frustrate the objectives of the business.
  • Reduction in the rate of return on total investment.
  • Credit standing with banks will be adversely affected.

Collection Methods

Collection methods are designed to speed up the process of realizing or collecting accounts receivable in other words, they are designed to reduce the delay between the time a customer pays his bills and the time a cheque is collected and cashed to become a useful fund.

The methods include:

  • Concentration Banking: This refers to the establishment of strategic collection centers instead of centered at the office of an organization.
  • Lockbox: Under this system, a firm chooses a regional bank and asks its customer to mail or take their remittances to the lockbox which the bank pick up and deposit the cheques in the firm’s account.
  • Personal Collection of Cheques: A firm can send its employees to personally collect cheques from its customers.

Disbursement Methods

Disbursement methods are aimed at paying accounts payable (liabilities) as late as possible bearing in mind the need to maintain credit standing.

Various approaches to maximizing cash disbursement float are:

  • Slowing a Down Payment that Attracts Cash Discounts Until the Due Date: If for instance a firm has an obligation to pay its suppliers their money, if the benefits are lower than the forfeiture the firm should not pay until the 30th day but if the benefits associated with the discounts are greater the firm should make the payment on the 10th
  • Use of Drafts: A firm can also delay disbursement through the use of drafts because drafts, unlike a cheque, are not payable on demand, they must be presented to the issuer for acceptance. The draft arrangement delays the time the firm has to have funds on deposits to cover the drafts it issues. This point may not apply to some countries dues to changes in the banking system.
  • Remote Disbursing or Using Out-of-Town Cheques: Under this approach, a company opens many bank accounts that are located in different parts of the country or region and makes disbursements by issuing out-of-town cheques. With this arrangement, the period during which a cheque will remain outstanding is made longer. This is due to inefficiencies of the postal system the cheque clearing system and also the inefficiency of commercial banks in which the company making payments maintains accounts.
  • Maintaining a Payroll Disbursement Account: separate account for payroll disbursement by a company and at the same time predicting when its employees will present their cheque for payment is another approach to maximizing cash disbursement float. If for instance, the payday falls on Friday, not all employees will go to their banks on that day the company should then make predictions based on past experiences as to determine what percentage of its be issued cheques may be presented to the bank on Friday, Monday, it will also estimate the funds it needs to have on deposit to cover the payroll cheques. The magnitude of possible deviations from the expected behavior of its employers relating to the collection of salaries also needs to be studied by the company. This approach can also be extended to payments of dividends to common stock can also be extended to payments of dividends to common stockholders.
  • Issuance of Post-Dated Cheques: Post-dated cheques are issued to suppliers in settlement of debts, the cheque cannot be cashed before the date written on them but this has to be based on an agreement reached between the company and its suppliers.

The maximization of cash disbursement float has certain disadvantages, for instance, if care is not taken the creditworthiness of a firm will be affected negatively. Secondly, the use of a draft involves the payment of service charges by the firms and some suppliers may prefer cheques to drafts.

 

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