Working Capital Management

Working capital management takes the decision to invest in short-term assets. Current assets of the firm comprise cash, receivables and inventory. Working capital management decides how much money should be invested in each of these assets. This decision is crucial as it affects the liquidity and the profitability of the firm. If the company invests its entire fund in the current asset, then, it will not be able to invest in the risky and long-term assets.

This will result in lesser profits but the liquidity will be high. On the other hand, if the firms do not invest in the short term, then there will be a risk of short-term insolvency, but profitability will be high. Gross working capital is known as the current assets of the firm. Net working capital is the difference between current assets and current liabilities.

Approaches to Working Capital:

It deals with determining what proportion of working capital should be financed by long-term sources and how many by short-term sources.

Hedging/Matching Approach: It suggests that permanent working capital should be financed by long-term sources and the temporary working capital should be funded by short-term sources.

Conservative Approach: It suggests that the entire working capital, i.e. investment in current assets should be financed by long-term sources should be used only for emergency purposes.

Aggressive Approach: It suggests that the entire working capital should be financed from short-term assets and even a part of fixed asset investment must be financed with short-term assets.

Determinants of Working Capital Management:

Nature of Business: This is a significant factor that determines the amount of working capital required by various firms. If the firm is a manufacturing company then it requires more liquid assets to deal with daily operation, hence the working capital requirement will be high. Companies that are trading enterprises have a lower level of working capital requirements.

Length of the Period: If a company takes more time to produce finished goods, then the working capital will be high.

The volume of the Business: The size of the firm determines the requirement of working capital. When the firm operates on a large scale it requires heavy working capital, while a small enterprise can work with smaller levels of working capital.

The proportion of raw materials: If the cost of raw material has a high proportion in the total cost of production, then the company requires high levels of working capital in order to finance its day-to-day activities. Whereas, when the cost is a very small proportion of the entire cost, then the working capital requirement is low.

Seasonal Variation: Some industries are either producing goods or selling only all year around. e.g. The wooden textile industry ultimately makes its revenues during the winter months. Thus, for these companies, working capital requirement rises during these months and falls during the off-season.

Business Cycle: When there is a boom condition then there is an upsurge in economic activity. Thus, there is high working capital requirement. When there is a recession in the economy, then there is a lesser requirement of working capital.