Working Capital Management

Hello friends, let’s learn about working capital today.

What is working capital – Working capital is the amount which a company use for its day-to-day operations. It is actually the difference of current assets and current liabilities.

Example – for buying raw material, pay bills, and manage its short-term expenses.

Working capital = current Assets – current liabilities

It indicates how much short-term money any business needs to run easily.

Example: - Current Assets = 3,00,000

Current Liabilities = 2,00,000

Working Capital = 3,00,000 – 2,00,000 = 1,00,000

Here Working capital means the company have ₹1,00,000 extra to run day-to-day work easily.

Ok, Now understands what is working capital Management

Working Capital management meaning management of short-term assets and short-term liabilities (like cash, inventory, receivables, payables) in a clever way to

Run business smoothly, optimisation of money for making good profit, and there should be no shortage of cash.

What is Working capital Cycle

Company buys raw material inventory on credit – (uses cash → inventory).

then sell the inventory to customer on credit – (inventory → receivables).

after sometime they receive money (Cash) from customer – (receivables → cash).

 

and the Cash pay to the party from whom company bought the raw material inventory and other Current Liabilities

                                             

Raw Material → Work-in-Progress → Finished Goods → Debtors → Cash → Again buy Raw Material.

The shorter this cycle, the better for the business — because money moves faster.

What is included in Current Assets and Current Liabilities

Current Assets: Current assets includes - Cash, Debtors (Accounts Receivable), Inventory, Marketable securities, Prepaid expenses, Short-term loans and advances.

Current Liabilities: Creditors (Accounts Payable), Short-term loans, Accrued Expenses, Salaries Payable, Short- term loans, Unearned Revenue (or Deferred Revenue), Unearned Revenue (or Deferred Revenue).

Purposes of Working Capital Management:

·       Optimize bill payments

·       Improve your accounts receivable.

·       Reduce interest cost (Financing cost).

·       Maintain enough liquidity (cash flow).

·       Avoid keep free funds (don’t keep too much cash). Optimise funds

·       Reduce inventory and carrying costs

Methods / Approaches for Working Capital Management

A)  Matching Approach (Moderate Policy):

Use → short-term funds for Short-term needs &

Use → long-term funds for Long-term needs

Balanced risk & return.

B)   Conservative Approach:

Use more long-term funds (safe side). Here the management use long term funds for short term needs.

Less risk, less profit.

C)   Aggressive Approach:

Use more short-term funds (risky side). Here The management use short term funds for short term & mid long-term needs

More profit, more risk.

Working capital ratio – Current ratio

Working capital ratio = current assets / current liabilities

So, we understood here that the main point is Cash here. If you manage Cash properly you are good in working capital management.

 

Here we come to a new concept of Cash conversion cycle –

 

The cash conversion cycle formula is: Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO) = Cash Conversion Cycle (CCC)

 

A)  Days Inventory Outstanding tells you how long it takes to sell your inventory.

 

Days Inventory Outstanding = (Inventory/COGS) x Days in Period

 

B)   Days Sales Outstanding the average number of days it takes a company to collect payment from its customers after a sale has been made

 

Days Sales Outstanding = Days in Period x (Average Accounts Receivable/Revenue) 

 

C)   Days Payables Outstanding =   Days in Period x Average Accounts Payable/COGS)

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