Working Capital Management Essay Example

Working Capital Management Essay Introduction of study In the present competitive world, every firm, whether big, medium of small, needs working capital to carry on its operations and to achieve its targets. Proper management of working capital is an important role of firm’s life. Working capital is essential to maintain the smooth running of business. No business can run successfully without an adequate amount of working capital. Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds, which earns no profits for business. Working capital management policies of a firm have a great effect on its profitability, liquidity and structural health of the firm. A well-designed and implemented working capital management is expected to contribute positively to creation of firm’s value profitability. A firm is required to maintain a balance between liquidity and profitability while conducting its day-to day operations. Liquidity is a pre condition to ensure that firms are able to meets its short-term obligations and its continued flow can be guaranteed from a profitable venture. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role with in the business. This requires that business must be run profitability. Profit maximization is generally considered important objective of a business. Profit is also used as a tool for evaluating the performance of management. Profitability directly influences the creation of surpluses. Therefore, Management of working capital is one of the most important aspects of firm’s profitability. We will write a custom essay sample on Working Capital Management specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Working Capital Management specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Working Capital Management specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Analyzing the financial statement of the firm helps to make proper decisions about the strengths and weakness of the firm’s operations. These statements are useful in analysis of the profitability of the company by analyzing each individual element to the total figure of the statement. The statements will also assist in analyzing the profitability of the years and with the figures of the competitive firm in the industry for making analysis of relative efficiency. In sri-lanka, selected all listed companies are divided as the sectors by Colombo stock exchange. Here researcher considers Impact of working capital management on profitability of the five firms in trading industry in listed companies and do research based on the five years data between the 2003-2007 1. 2. Research problem Research problem is focused in this research as follows. 1. Does the working capital management impact on profitability of trading firms in sri-lanka? 2 Are the current assets, current liabilities, working capital, current ratio, liquidity ratio, efficieny ratio of selected Trading firms near to the industry average? 1. 3. Objective of the study The focus of this study is Impact of working capital management on profitability of the trading industry in listed companies in srilanka . The basic objective of the study is. †¢ Assess the relationship between working capital and financial performance. Sub objectives are †¢ Identify the need and importance of working capital †¢ To analyze the financial position of trading firms 1. 4. Significance of the study This study will help to know how to impact on working capital on profitability of selected Trading firms. This study also helps to estimate the working capital decisions on the companies’ profitability. Therefore, to estimate profitability, financial, and effectiveness of firm and find out the weakness of the firm. This research will help to know profitability and compare with competitive firms. It is important to improve the competitiveness and liquidity of the trading sector in order to enhance its efficiency. As well as, this study will create the further research question for further investigation in future. The fast growing but large company also makes use of current liability financing. For these reasons, the financial manger and staff devote a considerable portion of their time to working capital matters. Thus, working capital management of selected trading firms is most important. 1. 5. Chapter outline Chapter one includes background of the study, research problem, objective, significance, chapter outline of the study The second chapter consists of the detailed literature survey of the study. Literature survey of the study describes concepts of working capital, need for working capital, operating cycle concept, permanent and variable working capital, factors determining working capital, excess and inadequate working capital, ratio analysis, overtrading The third chapter is allocated to discuss the methodology and conceptualization of the study in detail. That is research problem will be conceptualized based on the literature review. Hypotheses are formulated according to the conceptual model and literature review. Next operationlalization, data collection techniques and method of analyzing impact of working capital management on the profitability of trading firms. The fourth chapter presents survey data presentation, which gathered through secondary data from annual report published by trading firms. Then data analyses are made by correlation analysis, regression analysis. These data are presented by using tables. The fifth chapter will discuss the findings of the research based on the presented and analyzed data. The, hypothesis will be tested. Finally, it indicates conclusion and suggestion for further research. CHAPTER-02 LITERATURE REVIEW 2. 0 Introduction In this chapter, the discussion is focused up on the existing literature that describes what is already identified the concepts and theories about the research problem and already carried out the research findings about working capital management and financial performance. 2. 1 Review of theoretical concept 2. 1. 1 Meaning of working capital Every Business needs funds for two purposes- for its establishment and to carry out its day – to- day operations. Long – term funds are required to create production facilities through purchase of fixed assets such as plant and machinery etc. Funds are also needed for short – term purpose for the purchase of raw materials, payment of wages and other day – today expenses etc. These funds are known as working capital. In simple words, working capital refers to the part of the firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories. In the words of shubin, â€Å"working capital is the amount of funds necessary to cover the cost of operating enterprise† According to Genestenberg, â€Å"circulating capital means current assets of a company that are changed in the ordinary course of business from one from to another, as for example, from cash to inventories, inventories to receivables, receivables into cash. † (Shashi K. Gupta, Neeti Gupta 2005P. 6. 1) 2. 1. 2 Concepts of Working capital Management The concept of working capital has been a matter of great controversy among the financial wizards. Different views on working capital can be classified into two groups, 1. Gross working capital According to this concept, working capital refers to the sum of all currents assets of the enterprise employed in business process. This is a going concern concept, since the financial manager is highly concerned with the management of assets with a 2. Net working capital This concept represents excess of current assets over current liabilities. It is also that portion of a firm’s current assets which is financed by long-term funds. Net working capital = current assets- current liabilities (I. M PANDY 1999 p807-808) 2. 1. 3 Kinds of working capital Working capital can be classified into two categories on the basis of time, 1. Permanent or Fixed working capital Permanent working capital represents current assets required on a continuous basis over the entire year. A manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to ensure uninterrupted production and sales. Likewise, some amount of funds remain tied in receivable when the firm sells goods on credit items. Some amount of cash has also to be held by the firm so as to exploit business opportunities, meet operational requirements and to provide insurance against business fluctuations. Thus minimum amount of current assets which the firm has to hold for all time to come to carry an operation at any time is termed as permanent or regular working capital. Permanent working capital has the following characteristics. 2. Temporary or Variable working capital It represents the additional assets, which are required at different times during the operating year additional inventory, extra cash. It is temporarily invested in current assets and possesses the following characteristics. Y Temporary working capital Permanent working capital X Time Fig-1:-permanent and temporary working capital From fig-1, it is clear that the need for regular working capital remains the same for whole the year, where as variable working capital needs are some times high and some times low. In a going concern, the need for working capital goes on rising because of increase in the level of business activities. It is presented in figure-2 Y [pic]X Time Fig-2:-permanent and temporary working capital 2. 1. 4 Operating Cycle Funds, thus, invested in current assets keep revolving fast and are being constantly converted into cash and this cash flows out again in exchange for other current assets. Hence it is also known as revolving capital. The circular flow concept of working capital is based upon this operating or working capital cycle of a firm. The cycle starts with the purchase of raw material and other resources and ends with the realisation of cash from the sale of finished goods. It involves purchase of raw material , its conversion into stock of finished good through work-in-progress with progressive increasement of labour and service costs, conversion of finished stock into, debtors and receivables and ultimately realitisation of cash and this cycle continues again form cash to purchase of raw material and soon. The speed / time duration required to complete one cycle determines the requirements of working capital- longer the period of cycle, larger is the requirement of working capital. Operating cycle of manufacturing firm Source: I. M. PANDEY, 1999, P 810 2. . 5 Importance of operating cycle The application of operating cycle concept is mainly useful to ascertain the requirement of cash working capital to meet the operating expenses of a going concern. This concept is based on the continuity of the follow of values in a business operation. This value usually in a going concern. Centre, mainly around the operational activities of a business in any period. This is an importance concept because the longer the operating cycle, there more working capital funds the firms needs. The management must ensure that this cycle does not become too long. Thus oncept more precisely measures the working capital fund requirements, traces its changes and determinants the optimum level of working capital requirements. [TAXMANN 2003, P 654] 2. 1. 6 Factors determining the working capital requirements. The working capital requirements of a concern depend upon a large number of factors such as nature and size of business, the character of their operations, the length of production cycles, the rate of stock turnover and state of economic situation,. It is not possible to rank them because all such factors are of different importance and the influence of individual factors changes for a firm over time. However, the following are important factors generally influencing the working capital requirements. 1. Nature or Character of business. The working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like electricity, water supply and railways need very limited working capital because the offer cash sales only and supply services, not products as such no funds are tied up in inventories and receivables. On the other hand, trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets like inventories, receivables and cash. The manufacturing undertaking also requires sizable working capital along with fixed investments. 2. Size of business or Scale of operations The working capital requirements of a concern are directly influenced by the size of its business, which may be measured in terms of scale of operations. Greater the size of a business unit, generally larger will be the requirements of working capital. However, in some cases even a smaller concern may need more working capital due to high overhead charges, inefficient use of available resources and other economic disadvantage of mall size. 3. Production policy In certain industries, the demand is subject to wide fluctuations due to seasonal variations. The requirements of working capital, in such cases, depend upon the production policy. The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season. If the policy is to keep production steady by accumulating inve ntories it will require higher working capital. 4. Manufacturing Process or Length of production Cycle. In manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw materials and other supplies have to be carried for a longer period in the process with progressive increment of labour and services cots before the finished product is finally obtained. Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen. . Working capital Cycle. In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sale of finished products. This cycle involves purchase of raw material and stores, its conversion into stocks of finished goods through work-in-progress with progressive increment of labour and service costs, conversion of finished stock into sales, de btors and receivables and ultimately realization of cash and this cycle continues again from cash to purchase of raw material and so on. 6. Credit policy The credit policy of a concern in its dealings with debtors and creditors influence considerably the requirements of working capital. A concern that purchases its requirements on credit and sells its products or services on cash requires lesser amount of working capital. On the other hand a concern buying its requirements for cash and allowing credit to its customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors. 7. Rate of growth of business. The working capital requirements of a concern increase with the growth and expansion of its business activities. Although, it is difficult to determine the relationship between the growth in the volume business and the growth in the working capital of a business, yet it may be concluded that for normal rate of expansion in the volume of business, We may have retained profits to provide for more working capital but in fast growing concerns, We shall require larger amount of working capital. 8. Earning capacity and Dividend policy. Some firms have more earning capacity than others due to quality of their products, Monopoly conditions etc. Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital. The dividend policy of a concern also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits needs more working capital than the firm that retains larger part of its profits and does not pay so high rate of cash dividend. 9. Price Level Changes. Changes in the price level also affect the working capital requirements. Generally, the rising prices will require the firm to maintain larger amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms. Some firms may be affected much while some others may not be affected at all by the rise in prices. 10. Other factor. Certain other factors such as operating efficiency management ability, irregularities of supply, import policy, asset structure, importance of labour, banking facilities, etc also influence the requirements of working capital. . 1. 7 Excess and inadequate working capital Business should maintain sound position of working capital. The amount of working capital should neither be too excessive, nor too much inadequate. The working capital in excess of the requirement will reduce profitability as the funds will remain unutilized. Controrily, if the amount of working capital is less that what it is required, the production process may be hampered. It will reduce the sales and consequently the profitability of the business will be adversely affected. 2. 1. 8 Management of working capital Management of working capital therefore, is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter- relationship that exists between them. In other words it refers to all aspects of administration of both current assets and current liabilities . Working capital management (WCM) is the management of short-term financing requirements of a firm. This includes maintaining optimum balance of working capital components – receivables, inventory and payables – and using the cash efficiently for day-to-day operations. Optimization of working capital balance means minimizing the working capital requirements and realizing maximum possible revenues. Efficient WCM increases firms’ free cash flow, which in turn increases the firms’ growth opportunities and return to shareholders. Even though firms traditionally are focused on long term capital budgeting and capital structure, the recent trend is that many companies across different industries focus on WCM efficiency. The basic goal of working capital management is to manage the current assets and current liabilities of a firm in such a way that a satisfactory level of working capital is maintained. Working capital management policies of a firm have a great effect on its profitability, liquidity and structural health of the organization. In this context, working capital management is three dimensional in nature: (1) Dimension I is concerned with the formulation of policies with regard to profitability, risk and liquidity. (2) Dimension II is concerned with the decisions about the composition and level of current assets. (3) Dimension III is concerned with the decision about the composition and level of current liabilities. (Shashi K. Gupta, Neeti Gupta 2005 P. 6. 12) 2. 1. 9 Previous research findings on working capital Management. The study of Grablowsky [1976] and others showed a significant relationship between various success measures and the employment of formal working capital policies and procedures. Walker and Petty [1978], Deakins et al [2001] said that managing cash flow and conversion cycle is a critical component of overall financial management for all firms, especially those who are capital contrained and more reliant on short term sources of finance. Carpenter and Johnson [1983] provided that there is no linear relationship between the level of current assets and revenue systematic risk of US firms. Pinches 1991, Brigham and Ehrhardt 2004, Moyer et. al. 2005, Gitman2005). Said that , there is a long debate on the risk/return tradeoff between different working capital policies. For the first time, Soenen [1993] indicated that a negative correlation between the length of net trade cycle and return on assets. Lamberson [1995] said that the most of the financial managers’ time and efforts are allocated in optimizing the level of current assets and current liabilities back towards optimal levels. Jarvis et al [1996] concluded that the success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements. Pandy I M Perera K L W [1997] suggested that The managing director plays a major role in formulating formal or informal policy. Company size has an influence on the overall working capital policy (formal or informal) and approach (conservative, moderate or aggressive) Finance manager is the responsible for managing working and review period. capital components. Stretching of credit payment and ageing schedule are the primary tools of managing disbursement float and controlling debtors respectively. Material requirement planning (MRP) and perpetual inventory control (PIC) system are key techniques of inventory management. Company profitability and working capital policy influence the payable management and working capital finance respectively. Most of the companies take cash discounts, but their annual cost of working capital funds is high that ranges between Current and cash budget are major techniques of working capital, 15-20%. planning and control. Company profitability has an influence on the methods of working capital planning and control. Companies sometimes consider working capital changes when they evaluate capital budgeting. Most of the companies in this study use bank interest rate as a hurdle rate for evaluating the working a comparison of the working capital practices of the Sri Capital changes. Lankan companies with the USA companies reveals a lot for similarities. The basic difference is in terms of the use of computerized system and the opportunity to invest surplus cash in the money market instruments. Herbert J. Weinraub and Sue Visscher [1998] found that there is a high and significant negative correlation between industry asset and liability policies. Relatively aggressive working capital asset management seems balanced by relatively conservative working capital financial management. The study undertaken by Peel et al [2000] revealed that small firms tend to have a relatively high proportion of current assets, less liquidity, exhibit volatite cash flows, and a high reliance on short-term debt. Jain and Kumar (1999) examined and compared that current liability management practices of select companies in India and South-East Asia. Accounts payable, and short-term loans and advances, were found to be the two major ingredients of total current liabilities. Further, the majority of the sample companies in India and SEA indicated that suppliers offered cash discount facility for prompt payment. Most of the sample companies from India, Singapore and Malaysia did not seem to use any ‘manual’ for working capital management The length of operating cycle had been stated as the basis of working capital determination in India, while, percentage of budgeted production/sales had been ranked as the primary basis in Singapore and Malaysia for that purpose. They also revealed that the majority of the sample companies in India, Singapore and Malaysia had experienced occasional shortage as well as surplus of working capital. Jain and Yadav (2000) conducted an empirical study on the comparative current assets management practices of corporate enterprises in India, Singapore and Thailand. It was found that the vast majority of the sample companies in India as well as Singapore and Thailand had singled out bank overdraft/cash credit as the major source of dealing with cash deficit situations. The survey also found the multiple ways in which surplus cash was used by the corporate firms from the sample countries. Indian corporate firms followed the practice of deploying excess cash primarily by investing in short-term marketable securities, retiring short-term debt and making deposits with bank for short period. Whereas, deposit with bank and retiring short-term debts were the preferred outlets for Singapore corporate enterprises and Thai firms. Most of the corporate firms in India generally offered cash discount facility to debtors, while their counterparts from Singapore and Thailand (all) did not follow the policy of offering discount to their debtors. Two-thirds of corporate firms in India charged penal interest on overdues, whereas majority of the firms both in Singapore and Thailand did not charge any penal interest on overdue accounts. William Muffee Visemith [2001] said that Cameroon Development Corporation (CDC) is a very large corporation and working capital problems are very likely The study found that CDC has acute working capital problems resulting in losses These problems stem from poor working capital management approaches employed over the years. Every organization must seek a point of balance in its working capital in order to avoid a loss-making situation. Dr. Santanu Kr. Ghosh, Santi Gopal Maji [2002] indicated that the Indian Cement Industry as a whole did not perform remarkably well during this period Filbeck and Krueger [2005] highlighted that the importance of efficient working capital management by analyzing the working capital policies of financial industries in USA. According to their findings, working capital practices were significantly different overtime within the industries. Similar studies are conducted by Gombola and Ketz [1983] Soenen [1993] Max well et al [1998] and Long et al[1993]. Filbeck and Krueger [2005] said that business success heavily depends on the ability of financial executives to effectively manage receivables, inventory and payables. Md. Sayaduzzaman [2006] found that The efficiency of working capital management of British American Tobacco Bangladesh CompanyLtd. is highly satisfactory due to the positive cash in flows, planned approach in managing the major elements of working capital. Applications of multi-dimensional models of current assets mix may have positive impact on the continuous growth development of this multinational enterprise. This depends on co-operation of the stakeholders and business environment in the context of globalization. Appuhami, B A Ranjith [2008] found that firms capital expenditure has a significant impact on working capital management. The study also found that the firms operating cash flow, which was recognized as a control variable, has a significant relationship with working capital management. CFO Research Services (a unit of CFO Publishing Corp. ) launched a research program to explore working capital management among midsize and large U. S. companies. [2008] Through a survey and interview program, They sought to understand the relative importance of working capital management, the barriers companies face when they try to improve working capital management, and the steps they take to do so. Pradeep Singh [2008] found that the size of inventory directly affects working capital and its management. Size of the inventory and working capital of Indian Farmers Fertilizer Cooperative Limited (IFFCO) is properly managed and controlled compared to National Fertilizer Ltd. (NFL). Anita Agrawal, S. C. Bansal,[ ] showed that for some of the policy issues of WC, IC and their JV/WOS follow the same practices, while for some of the aspects they have different experiences. Indian firms and their overseas units have same opinion regarding objectives, concepts, frequency of revision of WC policy, determination, experience of shortage of WC and its consequences, reasons of excess WC and impact of environmental factors on WCM. It has been observed that on the whole the basic concepts of WCM remain same irrespective of the location of the firm, however, some differences appear due to distinct size, environment and goodwill of overseas ventures in their respective markets that makes the WCM of these units more complex. Michael J. Peel Nicholas Wilson [ ] indicated that a relatively high proportion of small firms in the sample claimed to use quantitative capital budgeting and working capital techniques and to review various aspects of their companies working capital. In addition, the firms which claimed to use the more sophisticated discounted cash flow capital budgeting techniques, or which had been active in terms of reducing stock levels or the debtors credit period, on average tended to be more active in respect of working capital management practices. 2. 2 financial performances The financial condition of a business organization of a business organization would depend on the resources it owns and the obligations it has to meets. Companies carry out various activities to make profits, and to generate wealth for further growth. Finance is considered as the most important for these activities. The actions of managers have financial consequences for the business firm. Therefore it is imperative that they know the importance of finance functions and their linkage with their own activities. (I. M. pandey, 1997) Hence financial position or condition of the firm should be assessed and future position of the companies should predict. To make the business activities in order to make profit, it would be necessary to keep the financial position favorably. Hence the present study is initiated to predict the financial position of the firms and to find out the linkage between financial position and profitability. Financial statements provide information about the financial positions of an enterprise that is useful to a wide range of users in making economic decisions. (chartered institution,1997) Evaluating the financial performance of the firm, in particular is profitability is required in order to potential changes in the economic resources that it is likely to control in the future. In formation contained in financial statements is organized to enable users of the financial statements to draw conclusions concerning the financial well-being and performance of the reporting entity. In about performance is useful in predicting the capacity of the enterprise to generate cash flows its existing resource base. Information contained in the statement is used by management, creditors, investors and others to form judgment about the operating financial performance and financial position of the firm. Management should be particularly interested in knowing the financial strengths of the firm to make their best performance and to be able to spot out the financial weakness. Each organization should therefore be in position of to repay the debts. In this way financial ratios are useful for assessing the financ