In your organization or any other organization of your choice how would you judge the efficiency of the Management of Working Capital, in the organization under study.
There are no set rules or formulae to determine working capital requirements of the firm. A large number of factors influence working capital needs of the firm. All factors are of different importance. Also, the importance of factors changes for a firm over time. Therefore, an analysis of relevant factors should be made in order to determine total investment in working capital.
The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from the firms’ point of view. Excessive working capital means idle funds which earn no profits for the firm. Paucity of working capital not only impairs firm’s profitability but also results in production interruptions and inefficiencies.
An enlightened management should, therefore, maintain a right amount of working capital on a continuous basis. Only then a proper functioning of the business operations will be ensured. Sound financial and statistical techniques, supported by judgment should be used to predict the quantum of working capital needed at different time periods.
A firms’ net working capital position is not only important as an index of liquidity but it is also used as a measure of the firms’ risk. Risk in this regard means chances of the firm being unable to meet its obligations on due date. Lender considers a positive net working capital as a measure of safety. All other things being equal, the more the net working capital a firm has, the less likely that it will default in meeting its current financial obligations. Lenders such as commercial banks insist that the firm should maintain a minimum net working capital.
There is an unavoidable need to manage working capital well. Working capital management refers to the administration of all aspects of current assets, namely cash, marketable securities, debtors and inventories and current liabilities. The financial manager must determine levels and composition of current assets. He must see that right sources are tapped to finance current assets, and that current liabilities are paid in time.
The current assets holdings of the firm depend on its working capital policy. It may follow a conservative or an aggressive working capital policy. These policies have different risk-return implications. A conservative policy means lower return and risk, while an aggressive policy produces higher return and risk. Any assessment of the firm’s working capital management should be within these policy frameworks. The two important aims of the working capital management are : profitability and solvency. Solvency used in the technical sense, refers to the firm’s continuous ability to meet maturing obligations. Lenders and creditors expect prompt settlements of their claims as and when due. To ensure solvency, the firm should be very liquid, which means larger current assets holdings. If the firm maintains a relatively large investment in current assets, it will have no difficulty in paying claims of creditors when they become due and will be able to fill all sales orders and ensure smooth production. Thus a liquid firm has less risk of insolvency; that is, it will hardly experience a cash shortage or stock-outs. However, there is a cost associated with maintaining a sound liquidity position. A considerable amount of the firm’s funds will be tied up in current assets, and to the extent this investment is idle, the firms’ profitability will suffer.
To have higher profitability, the firm may sacrifice solvency and maintain a relatively low level of current assets. When the firm does so, its profitability will improve as less funds are tied up in idle current assets, but its solvency would be threatened and would be exposed to greater risk of cash shortage and stock-outs.
To judge the efficiency of the management of working capital in a business enterprise we can look into the risk-return trade-off in terms of the cost of maintaining a particular level of current assets. There are two types of costs involved : the cost of liquidity and the cost of illiquidity. If the firms’ level of current assets is very high, it has excessive liquidity. It returns of assets will be low, as funds tied up in idle cash and stocks earn nothing and high levels of debtors reduce profitability. Thus, the cost of liquidity (through low rates of return) increases with the level of current assets.
For example, following are the hypothetical data for three firms following different working capital policies and their outcome :
Firms
A B C
. (Rs.) (Rs.) (Rs.)
Sales 15,00,000 15,00,000 15,00,000
Earnings before Interest & taxes (EBIT) 1,50,000 1,50,000 1,50,000
Current Assets 5,00,000 4,00,000 3,00,000
Fixed Assets 5,00,000 5,00,000 5,00,000
Total Assets 10,00,000 9,00,000 9,00,000
Return on total assets (EBIT/Total Assets) 15% 16.67% 18.75%
Current Assets/Fixed Assets 1.00 0.80 0.60
In determining the optimum level of current assets, the firm should balance the profitability-solvency tangle by minimizing total costs - cost of liquidity and cost of illiquidity. As indicated in the example and the above figure, that with the level of current assets the cost of liquidity increases while the cost of illiquidity decreases and vice versa. Hence the firm should maintain its current assets at that level where the sum of these two costs is minimized.
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