Finanzierung & Bilanzierung Studienarbeit - VersiónFinal

Finanzierung & Bilanzierung
MEM 2015
Financing and Accounting

The importance and potential of working capital management
Working Capital
Introduction to working capital:
Working capital represents the difference between a firms current assets and current
liabilities. In accounting, the term "current" refers to assets that can be turned into cash or
liabilities that are due in less than 12 months.
WorkingCapital=Current AssetsCurrent Liabilities

Current assets: Cash and other items of ownership which are expected to be converted
into cash in the ordinary course of business within a year. Common current assets are bills
receivable, stocks, cash, investments, etc.
Current liabilities: A company's legal debts or obligations that arise during the course of
business operations and that are expected to be cashed out within a year. Common current
liabilities are bills payable, dividends, short-term loans, taxation, etc.
A large amount of working capital means that the assets of the company are more than
sufficient to cover liabilities. Negative working capital means the company cannot pay
upcoming bills with the amount of money available or other assets that can be turned into
cash on short notice that it holds.
If current assets are less than current liabilities, an entity has a working capital deficiency,
also called a working capital deficit, which means that the working capital is negative.
A company can have assets and profitability but short of liquidity if its assets cannot easily
be converted into cash. Positive working capital is required to ensure that a firm is able to
continue its operations and that it has sufficient funds to satisfy both maturing short-term debt
and upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable, and cash.
Liquidity: In accounting, liquidity is a measure of the ability of a debtor to pay their debts
as and when they fall due. It is usually expressed as a ratio or a percentage of current
liabilities. Liquidity is the ability to pay short-term obligations.
Gatica, Pablo Roberto
Mejail, Emilio
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Rodriguez Sobral, Ernesto

MEM 2015
Working capital concept:
There are two major concepts of working capital net working capital and gross working
capital. Accountants define the term working capital as net working capital, which is the
difference between current assets and current liabilities. However, this concept makes little
difference because the concept is continuously changing. Financial analysts define working
capital as the sum total current assets their focus is on gross working capital. A financial
manager is involved with providing the correct amount of current assets for the firm at all
times.
In an ordinary sense, working capital denotes the amount of funds needed for meeting
day-to-day operations of a concern.
This is related to short-term assets and short-term sources of financing. Hence it deals
with both, assets and liabilities in the sense of managing working capital it is the excess of
current assets over current liabilities.
The funds invested in current assets are termed as working capital. It is the fund that is
needed to run the day-to-day operations. It circulates in the business like the blood circulates
in a living body. Generally, working capital refers to the current assets of a company that are
changed from one form to another in the ordinary course of business, i.e. from cash to
inventory, inventory to work in progress (WIP), WIP to finished goods, finished goods to
receivables and from receivables to cash.
Importance of Working Capital:

The importance of working capital can be better understood by the following:
It helps measure profitability of an enterprise. In its absence, there would be neither
production nor profit.

Without adequate working capital an entity cannot meet its short-term liabilities in time.
A firm having a healthy working capital position can get loans easily from the market due to
its high reputation or goodwill.

Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw
materials and payment of wages.

Sound working capital helps maintain optimum level of investment in current assets.
It enhances liquidity, solvency, credit worthiness and reputation of enterprise.
It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise
run successfully during periods of crisis.
Classification of Working Capital
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MEM 2015
The quantitative concept of Working Capital is known as gross working capital while that
under qualitative concept is known as net working capital. Working capital can be classified
in various ways. The important classifications are as given below:
Conceptual classification:
Gross Working Capital

Net Working Capital
Working Capital Deficit
Time-related classification:
Permanent
Variable
Financial classification:
Cash Working Capital

Balance Sheet Working Capital
Conceptual classification; There are two concept of working capital, quantitative and
qualitative. The quantitative concept takes into account as the current assets while the
qualitative concept takes into account the excess of current assets over current liabilities.
Deficit of working capital exists where the amount of current liabilities exceeds the amount of
current assets. The above can be summarised as follows:
Gross Working Capital = Total Current Assets

Net Working Capital = Excess of Current Assets over Current Liabilities
Working Capital Deficit = Excess of Current Liabilities over Current Assets.
Classification on the Basis of Variability; Gross Working Capital can be divided in two
categories. Such type of classification is very important for hedging decisions.
Temporary Working Capital: Temporary Working Capital is also called as fluctuating or

seasonal working capital. This represents additional investment needed during prosperity
and favourable seasons. It increases with the growth of the business. Temporary working
capital is the additional assets required to meet the variations in sales above the permanent
level. This can be calculated as follows:
Temporary WorkingCapital=Total Current Assets Permanent Current Assets
Permanent Working Capital: It is a part of total current assets which is not changed due to
variation in sales. There is always a minimum level of cash, inventories, and accounts
receivables which is always maintained in the business even if sales are reduced to a
minimum. Amount of such investment is called as permanent working capital. Permanent
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MEM 2015
Working Capital is the amount of working capital that persists over time regardless of
fluctuations in sales. This is also called as regular working capital.
Classification on the basis of financial reports; The information of working capital can
be collected from Balance Sheet or Profit and Loss Account; as such the working capital may
be classified as follows:
Cash Working Capital: This is calculated from the information contained in profit and loss
account. This concept of working capital has assumed a great significance in recent years as
it shows the adequacy of cash flow in business. It is based on Operating Cycle Concepts
which is explained later in this chapter.
Balance Sheet Working Capital: The data for Balance Sheet Working Capital is collected
from the balance sheet. On this basis the Working Capital can also be divided in three more
types: gross Working Capital, net Working Capital and Working Capital deficit.
Need for Working Capital:

Working capital plays a vital role in business. This capital remains blocked in raw
materials, work in progress, finished products and with customers. Working Capital is needed
for many reasons:
Adequate working capital is needed to maintain a regular supply of raw materials, which in
turn facilitates smoother running of production process.

Working capital ensures the regular and timely payment of wages and salaries, thereby
improving the morale and efficiency of employees.

Working capital is needed for the efficient use of fixed assets.
In order to enhance goodwill a healthy level of working capital is needed. It is necessary to
build a good reputation and to make payments to creditors in time.

Working capital helps avoid the possibility of under-capitalization.
It is needed to pick up stock of raw materials even during economic depression.
Working capital is needed in order to pay fair rate of dividend and interest in time, which
increases the confidence of the investors in the firm.
Working Capital and Cash flow:

Cash flow and working capital represent two critical measures of a company's ability to
meet its financial obligations. Many companies generate a significant amount of profit, but
insufficient cash. By analysing cash flow and working capital, an owner can determine
whether his small business is likely to face difficulties in paying upcoming bills.
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MEM 2015
Differences:
The key difference between these two figures is that working capital provides a snapshot
of the present situation, while cash flow is a measure of the company's ability to generate
cash over a specific period of time. Monthly or quarterly cash flows will naturally be very
different from the amount of cash generated over a 12-month period. As a result, working
capital provides an excellent idea about how easily the company can pay immediate
liabilities, while cash flow is more of a forward-looking measure. If the working capital is
insufficient but cash flow is satisfactory, the company could generate sufficient cash if given
enough time. If, however, creditors aren't willing to give enough time to such a company, it
could easily go bankrupt.
Divergence:
Under normal circumstances, companies with high cash flow also have high working
capital. However, several reasons can result in a divergence. Investing in equipment or
facilities, paying debt acquired a long time ago and paying dividends to stockholders can
drain cash and working capital even if the company has generated significant cash though
regular activities. Borrowing money and raising cash, on the other hand, will add to the cash
position as well as to working capital, even though the company is unable to generate much
cash under ordinary circumstances.
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MEM 2015
Working Capital Management

Definition
Working capital management is the management of the short-term investment and
financing of a company. Their goals are to adequate cash flow for operations and to make
the most out of the financial resources.
Long-term investment and financing decisions give rise to future cash flows which, when
discounted by an appropriate cost of capital, determine the market value of a company.
However, such long-term decisions will only result in the expected benefits for a company if
attention is also paid to short-term decisions regarding current assets and liabilities. Current
assets and liabilities, that is, assets and liabilities with maturities of less than one year, need
to be carefully managed. Working capital management is a key factor in the companys longterm success: without the oil of working capital, the engine of non-current assets will not
function. The greater the extent to which current assets exceed current liabilities, the more
solvent or liquid a company is likely to be, depending on the nature of its current assets.
To be effective, working capital management requires a clear specification of the
objectives to be achieved. The two main objectives of working capital management are to
increase the profitability of a company and to ensure that it has sufficient liquidity to meet
short-term obligations as they fall due and so continue in business. Profitability is related to
the goal of shareholder wealth maximisation, so investment in current assets should be
made only if an acceptable return is obtained. While liquidity is needed for a company to
continue in business, a company may choose to hold more cash than is needed for
operational or transaction needs, for example for precautionary or speculative reasons. The
twin goals of profitability and liquidity will often conflict since liquid assets give the lowest
returns. Cash kept in a safe will not generate a return, for example, while a six-month bank
deposit will earn interest in exchange for loss of access for the six-month period.
Importance of Working Capital Management

For smooth running an enterprise, adequate amount of working capital is very essential.
Efficiency in this area can help, to utilize fixed assets gainfully, to assure the firms long- term
success and to achieve the overall goal of maximization of the shareholders, fund. Shortage
or bad management of cash may result in loss of cash discount and loss of reputation due to
non-payment of obligation on due dates. Insufficient inventories may be the main cause of
production held up and it may compel the enterprises to purchase raw materials at
unfavourable rates.
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MEM 2015
Like-wise facility of credit sale is also very essential for sales promotions. It is rightly
observed that many a times business failure takes place due to lack of working capital.
Adequate working capital provides a cushion for bad days, as a concern can pass its period
of depression without much difficulty.
The adequacy of cash and current assets together with their efficient handling virtually
determines the survival or demise of a concern. An enterprise should maintain adequate
working capital for its smooth functioning. Both, excessive working capital and inadequate
working capital will impair the profitability and general health of a concern.
Meaning of Working Capital Management

The management of current assets, current liabilities and inter-relationship between them
is termed as working capital management. Working capital management is concerned with
problems that arise in attempting to manage the current assets, the current liabilities and the
inter-relationship that exist between them. In practice, There is usually a distinction made
between the investment decisions concerning current assets and the financing of working
capital.
From the above, the following two aspects of working capital management emerge:
1. To determine the magnitude of current assets or level of working capital and
2. To determine the mode of financing or hedging decisions.
Significance of Working Capital Management

Funds are needed in every business for carrying on day-to-day operations. Working
capital funds are regarded as the life blood of a business firm. A firm can exist and survive
without making profit but cannot survive without working capital funds. If a firm is not earning
profit it may be termed as sick, but, not having working capital may cause its bankruptcy
working capital in order to survive. The alternatives are not pleasant. Bankruptcy is one
alternative. Being acquired on unfavourable term as another. Thus, each firm must decide
how to balance the amount of working capital it holds, against the risk of failure.
Working capital has acquired a great significance and sound position in the recent past for
the twin objects of profitability and liquidity. In period of rising capital costs and scare funds,
the working capital is one of the most important areas requiring management review. It is
rightly observed that, Constant management review is required to maintain appropriate
levels in the various working capital accounts. Mainly the success of a concern depends
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MEM 2015
upon proper management of working capital so working capital management has been
looked upon as the driving seat of financial manager.
A study of working capital management is very important for internal and external experts.
Sales expansion, dividend declaration, plants expansion, new product line, increase in
salaries and wages, rising price level, etc., put added strain on working capital maintenance.
Failure of any enterprise is undoubtedly due to poor management and absence of
management skill.
Importance of working capital management stems from two reasons,
A substantial portion of total investment is invested in current assets, and

Level of current assets and current liabilities will change quickly with the variation in sales.
Though fixed assets investment and long-term borrowing will also response to the
changes in sales, but its response will be weak.
Working capital policies

Because working capital management is so important, a company will need to formulate
clear policies concerning the various components of working capital. Key policy areas relate
to the level of investment in working capital for a given level of operations and the extent to
which working capital is financed from short-term funds such as a bank overdraft. A company
should have working capital policies on the management of inventory, trade receivables,
cash and short-term investments in order to minimise the possibility of managers making
decisions which are not in the best interests of the company. Working capital policies need to
consider the nature of the companys business since different businesses will have different
working capital requirements. A manufacturing company will need to invest heavily in spare
parts and components and might be owed large amounts of money by its customers. A food
retailer will have large inventories of goods for resale but will have very few trade
receivables. The manufacturing company clearly has a need for a carefully thought out policy
on receivables management, whereas the food retailer may not grant any credit at all.
Working capital policies will also need to reflect the credit policies of a companys close
competitors, since it would be foolish to lose business because of an unfavourable
comparison of terms of trade. Any expected fluctuations in the supply of or demand for goods
and services, for example due to seasonal variations in business, must also be considered,
as must the impact of a companys manufacturing period on its current assets.
An aggressive policy with regard to the level of investment in working capital means that a
company chooses to operate with lower levels of inventory, trade receivables and cash for a
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MEM 2015
given level of activity or sales. An aggressive policy will increase profitability since less cash
will be tied up in current assets, but it will also increase risk since the possibility of cash
shortages or running out of inventory is increased. A conservative and more flexible working
capital policy for a given level of turnover would be associated with maintaining a larger cash
balance, perhaps even investing in short-term securities, offering more generous credit terms
to customers and holding higher levels of inventory. Such a policy will give rise to a lower risk
of financial problems or inventory problems, but at the expense of reducing profitability.
A moderate policy would tread a middle path between the aggressive and conservative
approaches. It should be noted that the working capital policies of a company can be
characterised as aggressive, moderate or conservative only by comparing them with the
working capital policies of similar companies. There are no absolute benchmarks of what
may be regarded as aggressive or otherwise, but these characterisations are useful for
analysing the ways in which individual companies approach the operational problem of
working capital management.
Figure 1: Different policies regarding the level of investment in working capital
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MEM 2015
Working Capital Cycle

Definition
The working capital cycle is the time required by the business operations to convert net
current assets and net current liabilities into cash.
From a more simplistic point of view, it is possible to understand the working capital cycle
as the time between investing in a product or service and receiving payment for that product
or service. The starting point of the working capital cycle is usually when the business
purchase raw materials or hires people for the service. The ending point of the working
capital cycle is when the customer makes the payment, regardless of whether such payment
comes pre-paid for the service or purchase, payment takes place at time of purchase or
obtaining the service, or the payment comes later owing to sale on credit.
For example, if a company purchase raw material and makes the payment to the supplier
on day 1, manufactures the product on day 7, and sells it on day 15, receiving payment from
the client on day 23, the working capital cycle is 23 days (See Table 1, Case A). If the
company receives the payment in the moment of the sale, the working capital cycle is only
15 days (See Table 1, Case B). Another interesting case is presented when the company
receives the payment from the client on the same day as buying the raw materials from the
supplier; in this case, the working capital cycle is 0 (See Table 1, Case C).
Table 1: Working capital cycle examples.
Case
A
B
C
Payment
to supplier
day 1
day 1
day 1
Product
manufacturing
day 7
day 7
day 7
Product
Client
WCC
sales
day 15
day 15
day 1
Payment
day 23
day 15
day 1
[days]
23
15
0
During the time framed by the working capital cycle, the company has to meet day-to-day
operational expenses, which can be done with own money reserves or by means of shortterms borrowing, with the correspondent interests. This can lead to extra cost, reducing in
consequence the companys profitability.
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MEM 2015
The length of the cycle is directly related to the sequence of steps involved in the
purchase and sale of assets. For example, for a manufacturing firm the normal cycle is:
1. Conversion of cash into raw materials.
2. Conversion of raw materials into work-in-progress.
3. Conversion of work in process into finished goods.
4. Conversion of finished goods into debtors and bills receivables through sales.
5. Conversion of debtors and bills receivables into cash.
Raw
material
Cash
Accounts
Receivables
Work in
progress
Finished
goods
Sales
Figure 2: General cycle for manufacturing concerns
Failure to move each asset through the cycle continuously leads to a breakdown of the
process and with it a liquidity crisis where the company cannot purchase additional raw
materials or make payments to sustain its operations. This can lead to a shutdown and even
bankruptcy.
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MEM 2015
The shorter the working capital cycle, the more effective is the working capital. It is
important to notice that the nature of the business has a significant impact in the length of the
cycle. For instance, non-manufacturing concerns, service concerns and financial concerns
does not have raw material and work-in-process so, in general, their cycle is shorter.
In any case, if the working capital cycle is too long, then the capital gets tied up in the
operational cycle without earning returns. Therefore, companies try to achieve shorter
working capital cycles to increase their business efficiencies.
Main elements of the working capital cycle

Four main elements can be distinguished in the working capital cycle: cash, creditors,
inventory and debtors. In order to achieve a successful cash-flow management, it is
needed to have complete control on each of these aspects. The shorter the working capital
cycle, the faster inventory can be converted into cash, thereby reducing the dependency for
cash on customer payments and loans.
Debtors
Cash
Inventory
Creditors
Figure 3: Working capital cycle main elements
Cash: The cash refers to the funds available for the purchase of goods. Maintaining a
healthy level of liquidity with some reserves is always a best practice. This will be needed in
case of shortage of cash inflow for any reason or contingency, allowing to continue with the
day-to-day operations without posing a threat to the solvency of the firm. In addition, the
business can profit from new appearing opportunities.
Creditors and Debtors: The creditors refer to the accounts payable and the amount
that has to be paid to suppliers for the purchase of goods and /or services. Debtors refer to
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MEM 2015
the accounts receivables and to the amount that is collected for providing goods and/or
services.
Inventory: Inventory refers to the stock in hand. Inventories are an integral component of
working capital and careful planning, and proper investment is necessary to maintain the
inventory in a healthy state of affairs. Management of inventory has two aspects and involves
a balance between cost and risk factors. Maintaining a sizable inventory has its consequent
costs that include locking of funds, increased maintenance and documentation cost and
increased cost of storage. On the other hand, maintaining a small inventory can disrupt the
business lifecycle and can have serious impacts on the delivery schedule. As a result, it is
extremely important to maintain the inventory at optimum levels which can be achieved after
careful analysis and practical experience.
Properties of a healthy working capital cycle

It is essential for the business to maintain a healthy working capital cycle. The following
points are necessary for the smooth functioning of the working capital cycle:
Sourcing of raw material: Sourcing of raw material is the beginning point for most
businesses. It should be ensured that the raw materials that are necessary for producing the
desired goods are available at all times. In a healthy working capital cycle, production ideally
should never stop because of the shortage of raw materials.
Production planning: Production planning is another important aspect that needs to be
addressed. It should be ensured that all the conditions that are necessary for the production
to start are met. A carefully constructed plan needs to be present in order to mitigate the risks
and avert unforeseen issues. Proper planning of production is essential for the production of
goods or services and is one of the basic principles that must be followed to achieve smooth
functioning of the entire production lifecycle.
Selling: Selling the produced goods as soon as possible is another objective that should be
pursued with utmost urgency. Once the goods are produced and are moved into the
inventory, the focus should be on selling the goods as soon as possible.
Payouts and collections: The accounts receivables need to be collected on time in order to
maintain the flow of cash. It is also extremely important to ensure timely payouts to the
creditors to ensure smooth functioning of the business.
Liquidity: Maintaining the liquidity along with some room for adjustments is another
important aspect that needs to be kept in mind for the smooth functioning of the working
capital cycle.
Uses and Applications
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MEM 2015
The working capital cycle indicates the time that the company has to block money on the
product or service before it gets back the money to manufacture additional products and or
reinvest some of the profits from the investment for further growth and research. A company
with short working capital cycle usually has a healthy cash flow, and companies with long
working capital cycles usually have cash flow difficulties. A lengthy working capital cycle
owing to credit sales mean that the company does not have cash to re-manufacture the
product even after selling the manufactured product.
As it has already been exposed, good working capital cycle management seeks to
balance incoming and outgoing payments by identifying and synchronizing dates of accounts
payable and accounts receivable. The ideal scenario for a company is to accomplish a
perfect balance between accounts payable and accounts receivable, so that the company
can maintain zero working capital and still operate smoothly. Companies such as Amazon
collect payment before starting the manufacturing process, and as such maintain negative
working capital levels. Other companies delay making payment to suppliers of raw materials
until getting payment from customer for the finished goods. Such companies always remain
flush with funds, and have zero working capital cycle. Adoption of just in time methodology
allows taking this concept even further.
There are several techniques that can be adopted by companies to manage the working
capital cycle such as:
Cash management: Identify the cash balance available to meet the day-to-day expenses,
taking care that cash holding costs are not increased

Inventory management: Managing inventories to allow a stable production while keeping
investments in raw materials low.

Debtors management: Involves taking decisions on the credit policy of the company,
managing discounts and allowances etc.

Short-term financing: Depending on the cash-conversion cycle, it is possible to decide for
short-term financing to meet inventory and operational expenses, without much implication
on the working capital.
Optimum Level of Working Capital

If the working capital is too high, then the business has unused funds that are not earning
any return (unless they are invested in short-term securities, for example). But if the working
capital is too low, then the business faces the threat of financial difficulties.
The first step in order to determine the adequate level of working capital is understanding
the business environment. For instance, a company that provides services in the software
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MEM 2015
domain will require lower levels of working capital in comparison with a manufacturing firm.
The reason is that the inventory levels are lower and the time required to deliver the service
and generate cash will also be shorter than that required to produce and sell goods.
The in second place, it is necessary to look at the recent balance sheet and take into the
account the current assets and current liabilities for calculations. Once the required working
capital has been determined, it is also important to know whether the safety margin is wide
enough to operate efficiently. For this, it is useful to calculate the working capital ratio.
Workingcapital ratio( current ratio)=
current assets
current liabilities
The current ratio is one of the liquidity ratios that will help to measure the capability of the
business to meet short term financial commitments. The higher the current ratio the better is
the capacity to meet short term financial obligations. In general, the target value for the
current ratio equals or exceeds 1,5. A current ratio less than one means the company has
insufficient assets to convert to cash and pay operating expenses and near-term liabilities.
This may indicate the company could be nearing financial distress if it does not obtain
financing. A current ratio of 1.5 means the company has more than enough assets to convert
to cash to cover its near-term needs.
Conclusion:
Most of the time, a companys working capital management is simply a part of its daily
operations, but it can indicate financial problems, especially when working capital runs in the
negative for an extended period of time.
Bibliography
I.M. Pandey: Financial Management, 4th edition McGraw-Hill, New Delhi (2004).
Schall, L. D., Haley, C. W.: Introduction to financial management, 6th edition McGraw-Hill,
New York (1991).
V.K. BI.T.I.I: Working Capital Management, 5th edition Anmol Publication, New Delhi
(2003).
Khan and Jain: Financial management, 4th edition McGraw-Hill, New Delhi (2004).
Narender Kumar Jain: Working Capital Management, 5th edition A.P.H., New Delhi (2004).
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Gatica, Pablo Roberto