DOWNLOAD PDF WORKING CAPITAL MANAGEMENT POLICIES

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1 Chapter 1 : Working Capital Management Strategies Working capital management is the management of short-term assets and liabilities to ensure the most financially efficient operation of the company. A good or positive working capital enables a firm to access finance from short-term creditors and even long term creditor. In the long-run creditors seek firms with a positive working capital since it serves as an assurance of loan repayment. The issue of a positive working capital calls for working capital management which according to Pandey He further states that the financial manager must determine levels and composition of current assets by determining the right source to finance current assets and that current liability are paid in time. The goal of working capital management is to ensure that the firm is able to continue its operation and that it has sufficient cash flows to satisfy both maturing short-term debt and upcoming operational expenses. In other words the study tries to ascertain the impact of working capital management policy variables like account receivable period policy, inventory period policy and cash conversion cycle policy on organization profitability taking Dangote Cement Plant Plc, Benue Plant as a case study. This is more so as it is expected that every corporate organization of any kind should make a fair return to justify its existence. In their research work, they discovered that there is a significant impact of working capital management policies on organizational profitability. The basic problem of this study is to ascertain whether or not working capital management policy has any significant impact on profitability of a firm. The study seeks to accomplish the following objectives: To determine the impact of accounts receivable policy on profitability of Dangote Cement Plc, Benue Plant. To ascertain the impact of inventory period policy on profitability of Dangote Cement Plc, Benue Plant. To investigate the impact of cash conversion cycle on profitability of Dangote Cement Plc, Benue Plant. It, therefore means holding more than enough of it is not cost effective and holding less than required means the firm may not be able to meet its current obligations when necessary. This put the company in a dangerous situation and affects the value of its stock. This study seeks to answer the following questions: Does account receivable policy have any significant impact on profitability of Dangote Cement Company Plc, Benue Plant? Does cash conversion cycle policy have any significant impact on profitability of Dangote Cement Company Plc, Benue Plant? Accounts receivables have no significant impact on the profitability of Dangote Cement Plc, Benue Plant. Cash conversion cycle does not have a significant impact on the profitability of Dangote Cement Plc, Benue Plant. However, this study is limited and covers the working capital management policies of Dangote Cement Company Plc, Benue Plant. The period under investigation is from to 1. It will be beneficial to students and researchers as it will add to the body of existing materials or knowledge which will open way for further research on related subject matters. This work will also be useful to policy formulators such as company mangers, as to the optimum working capital policy to adopt so as to bring about effective working capital management and enhance profitability. Chapter one; covers the background to the study, the statement of the problem, the objectives of the study, the research questions, research hypotheses, scope of the study, significance of the study and the structure of the study. Chapter two; reviews the literature related to the subject matter. It covers the introduction, theoretical or conceptual framework, review of prior studies and chapter summary. Chapter three; which is on research methodology, covers research design population and sample, definition of variables employed, types and sources of data, instruments of data collection, techniques of data processing and analysis, declaration of known problems with design, and chapter summary. Chapter four; presents data analysis and result; It covers data presentation, analysis, discussion and interpretation of results, and chapter summary. Chapter five; is on summary, conclusions and recommendations; It covers the summary of the project, conclusions, recommendations, limitations of the study and suggestions for further research. Secondly, we have provided our Bank Account on this site. Our Bank Account contains all information about the owner of this website. For your own security, all payment should be made in the bank. No Fraudulent company uses Bank Account as a means of payment, because Bank Account contains the overall information of the owner. These materials are to assist, direct you during your project. Study the materials carefully and use the information in them to Page 1

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3 Chapter 2 : Working Capital Policy â Relaxed, Restricted and Moderate Working capital management policy deals with the first decision and working capital management strategies or approaches deal with the second decision. Working capital policies are restricted, relaxed and moderate whereas the working capital strategies are aggressive, conservative and hedging (Maturity Matching). An aggressive policy means spending as much as possible to churn out products, move inventory and deliver services. With a conservative approach, money is being saved, and your business is buffered, somewhat, against risk. The optimal amount of working capital lies somewhere in between an aggressive and conservative approach. Current assets are cash or items that can convert to cash in less than a year, such as accounts receivable, negotiable securities and inventory. Current liabilities include the short-term payables: Aggressive Working Capital An aggressive working capital policy is one in which you try to squeeze by with a minimal investment in current assets coupled with an extensive use of short-term credit. Your goal is to put as much money to work as possible to decrease the time needed to produce products, turn over inventory or deliver services. Speeding up your business cycle grows your sales and revenues. You keep little money on hand, cut slow-moving inventory and unnecessary supplies to the bone and stretch out your bill payments for as long as possible. The one payment you cannot delay is interest -- your creditors can sue you, force you into bankruptcy and liquidate your assets. You would also want to avoid missing tax payments. Conservative Working Capital Companies in volatile or seasonal industries such as tourism, farming or construction might adopt conservative working capital policies to buffer against risk. Employees need not turn in their old pencils before they are allowed to have new ones. If you compute the working capital ratio -- current assets divided by current liabilities -- a conservative policy might yield a ratio above 2. Risks and Opportunity Costs The risk of default and bankruptcy increases as you adopt more aggressive working capital policies. For example, a sudden emergency can leave you unable to make a bond interest payment. Tight inventories can lead to shortages and lost sales. Vendors might balk at extending your further credit if you stretch out payments beyond 90 days. Investors might be less willing to buy your bonds and may force you to offer higher interest rates on newly issued long-term debt. A conservative policy lowers your sales efficiency -- sales revenue divided by working capital -- that can dissuade potential investors. Return on Assets An aggressive working capital policy can produce a higher return on assets, as measured by indicators such as gross income divided by working capital. However, while your indicators might rise, your absolute amount of gross income might fall. For example, as you tighten inventory, your sales and accounts receivable might swoon because you could run short of product. Inventory shortages might result in lower revenue and collections as competitors with well-stocked inventories steal your customers. A conservative policy might mean that some of your working capital is not working. This is like leaving money on the table -- you might have used the excess assets more productively to increase your return on assets. The optimal policy is one in which you allocate only the amount of working capital necessary to simultaneously maximize your revenues and minimize your risks. Page 3

4 Chapter 3 : Working Capital Management The level of aggressiveness of working capital policies depends to a considerable extent upon the availability of a large, untapped line of credit. If this is available, a company can risk an occasional negative cash situation, since cash can be readily replenished from the line of credit. The two terms are often used interchangeably. If, for example, a company lacks the working capital needed to expand production and sales, it may lose revenues and profits. Working capital is used by firms to maintain liquidity, that is, the ability to meet their cash obligations as they come due. Otherwise, it may incur the costs associated with a deteriorating credit rating, a potential forced liquidation of assets, and possible bankruptcy. Working capital management is a continuing process that involves a number of day-today operations and decisions that determine the following: In the case of fixed capital or long-term assets such as land, buildings, and equipment, a company usually needs several years or more to recover the initial investment. In contrast, working capital is turned over, or circulated, at a relatively rapid rate. Importance of Working Capital It has already been noted that a firm must have working capital to operate and survive. In many industries, working capital current assets constitutes a relatively large percentage of total assets. In the manufacturing sector, for example, current assets comprise about 40 percent of the total assets of all U. Among the wholesaling and retailing sectors, the percentages are even higherâ in the 50 to 60 percent range. For the five companies shown, current assets as a percentage of total assets range from about 25 percent to over 50 percent. ExxonMobil, with its relatively high percentage of fixed assets, has a relatively low percentage of current assets. In contrast,walgreens, a retail pharmacy chain, has a relatively high percentage of current assets. Walgreens, with a large number of retail outlets, has almost 37 percent of its assets invested in inventories. IBM, which finances customer purchases of some of its products, has about 28 percent of its assets in receivables. Because current assets constitute a relatively high percentage of total assets in most businesses, it is important to have effective working capital policies. In a survey of large industrial corporations, it was found that about 30 percent of the companies have a formal policy for the management of their working capital and another 60 percent have an informal policy. A significantly greater percentage of the larger companies within the sample have a formal policy than do the smaller companies. The president and treasurer are the next most frequently mentioned positions as having responsibility for working capital policy. There is considerable variation in the frequency with which companies review their working capital policy. Risk, as used in this context, deals with the probability that a firm will encounter financial difficulties, such as the inability to pay bills on time. All other things being equal, the more net working capital a firm has, the more likely it is to be able to meet current financial obligations. Many loan agreements with commercial banks and other lending institutions contain a provision requiring the firm to maintain a minimum net working capital position. Likewise, bond indentures also often contain such provisions. These activities create cash flows that are both unsynchronized and uncertain. They are unsynchronized because cash disbursements for example, payments for resource purchases usually take place before cash receipts for example, collection of receivables. They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy. If the firm is to maintain liquidity and function properly, it has to invest funds in various short-term assets working capital during this cycle. It has to maintain a cash balance to pay the bills as they come due. In addition, the company must invest in inventories to fill customer orders promptly. And, finally, the company invests in accounts receivable to extend credit to its customers. Figure illustrates the operating cycle of a typical firm. The operating cycle is equal to the length of the inventory and receivables conversion periods: It is defined as follows: It is calculated as follows: The following equation is used to calculate the payables deferral period: An increase in the length of the operating cycle, without a corresponding increase in the payables deferral period, lengthens the cash conversion cycle and creates further working capital financing needs for the company. Table shows an actual cash conversion cycle analysis for Walgreen Co. This was due primarily to over a 2-day reduction in its inventory conversion period, indicating that the company was turning over its inventory at a faster rate. Its receivables conversion period actually Page 4

5 deteriorated slightly from to and its payables deferral period remained about the same. Page 5

6 Chapter 4 : The Importance of Working Capital Management in Avoiding Bankruptcy blog.quintoapp.com Working capital management is an important aspect of Business Organization, and it is all about the working capital management that company easily meet the day to day expenses of business. Before going in depth of working capital management, we should know about the working capital. Small businesses in particular must strike a perfect balance between the two to successfully continue operations, because they lack the capital to absorb large losses. Proper working capital management proves essential in the avoidance of bankruptcy by helping a business balance needs with obligations. A full description of the relationship between working capital and bankruptcy requires an explanation of the relevant terminology. Working Capital Two basic definitions exist for working capital. The more technical of the two explains working capital as the difference between all short-term assets and short-term liabilities. Assets in business refer to anything of value a company owns. Liabilities are outstanding debts, such as loans and credit. The simpler definition describes working capital as the cash available for the day-to-day operations as a business. Daily operations cash comes from assets such as the sale of merchandise, and excludes money used to pay liabilities; therefore, the two definitions are essentially the same. Working Capital Management Working capital management entails the process of balancing the needs of short-term assets and short-term liabilities. Aspects of working capital management include short-term loans, merchandise purchased on credit, goods and services provided on credit and merchandise, goods and services paid for upon delivery. Managing working capital essentially entails managing the cash flow of a business on a daily, weekly and monthly basis in such a way that satisfies all debts while reserving enough capital to continue operations and the generation of profits. Management and Bankruptcy Businesses face bankruptcy when insufficient capital resources prevents them from paying debts owed. Successful working capital management allows a business to pay all debts as they mature, or come due, while continuing profitable business operations. At the very least, successful working capital management allows a business to break even. Therefore, working capital management is directly responsible for the avoidance of bankruptcy. Unsuccessful working capital management can lead directly to bankruptcy by preventing a business from paying off liabilities or by preventing the generation of new capital with which to pay future debts. Improving Working Capital and Management Several methods of improving working capital and working capital management exist. Methods of improving working capital management begin with simple tasks such as monitoring expenditures and upcoming debts daily, weekly and monthly and planning in advance how to balance the two. Lowering production costs while maintaining sales revenue increases profits, thus providing more cash for working capital management. Short term working capital management problems can be solved by swapping short-term debt for long-term debt and putting money allocated for short-term debt into the generation of profits for paying off long-term debt. Page 6

7 Chapter 5 : Aggressive vs. Conservative Working Capital blog.quintoapp.com An aggressive working capital policy is one in which you try to squeeze by with a minimal investment in current assets coupled with an extensive use of short-term credit. The following points highlight the top approaches of working capital management strategies. Zero Working Capital Approach 5. A conservative strategy suggests not to take any risk in working capital management and to carry high levels of current assets in relation to sales. Surplus current assets enable the firm to absorb sudden variations in sales, production plans, and procurement time without disrupting production plans. It requires to maintain a high level of working capital and it should be financed by long-term funds like share capital or long-term debt. Availability of sufficient working capital will enable the smooth operational activities of the firm and there would be no stoppages of production for want of raw materials, consumables. Sufficient stocks of finished goods are maintained to meet the market fluctuations. The higher liquidity levels reduce the risk of insolvency. But lower risk translates into lower return. Large investments in current assets lead to higher interest and carrying costs and encouragement for inefficiency. But conservative policy will enable the firm to absorb day to day business risks and assures continuous flow of operations. Under this strategy, long-term financing covers more than the total requirement for working capital. The excess cash is invested in short-term marketable securities and in need, these securities are sold-off in the market to meet the urgent requirements of working capital. Under this approach current assets are maintained just to meet the current liabilities without keeping any cushion for the variations in working capital needs. The core working capital is financed by long-term sources of capital, and seasonal variations are met through short-term borrowings. Adoption of this strategy will minimize the investment in net working capital and ultimately it lowers the cost of financing working capital. The main drawbacks of this strategy are that it necessitates frequent financing and also increases risk as the firm is vulnerable to sudden shocks. A conservative current asset financing strategy would go for more long-term finance which reduces the risk of uncertainty associated with frequent refinancing. The price of this strategy is higher financing costs since long-term rates will normally exceed short term rates. But when aggressive strategy is adopted, sometimes the firm runs into mismatches and defaults. It is the cardinal principle of corporate finance that long-term assets should be financed by long-term sources and short-term assets by a mix of long and short-term sources. Under matching approach to financing working capital requirements of a firm, each asset in the balance sheet assets side would be offset with a financing instrument of the same approximate maturity. The basic objective of this method of financing is that the permanent component of current assets, and fixed assets would be met with long-term funds and the short-term or seasonal variations in current assets would be financed with short-term debt. If the long-term funds are used for short-term needs of the firm, it can identify and take steps to correct the mismatch in financing. Efficient working capital management techniques are those that compress the operating cycle. The length of the operating cycle is equal to the sum of the lengths of the inventory period and the receivables period. Just-in-time inventory management technique reduces carrying costs by slashing the time that goods are parked as inventories. To shorten the receivables period without necessarily reducing the credit period, corporate can offer trade discounts for prompt payment. This strategy is also called as hedging approach. Zero Working Capital Approach: This is one of the latest trends in working capital management. The idea is to have zero working capital i. Excess investment in current assets is avoided and firm meets its current liabilities out of the matching current assets. As current ratio is 1 and the quick ratio below 1, there may be apprehensions about the liquidity, but if all current assets are performing and are accounted at their realizable values, these fears are misplaced. The firm saves opportunity cost on excess investments in current assets and as bank cash credit limits are linked to the inventory levels, interest costs are also saved. There would be a self-imposed financial discipline on the firm to manage their activities within their current liabilities and current assets and there may not be a tendency to over borrow or divert funds. There would also be a constant displacement in the current liabilities and the possibility of having over-dues may diminish. The tendency to postpone current liability payments has to be curbed and working capital Page 7

8 always maintained at zero. Zero working capital would call for a fine balancing act in Financial Management, and the success in this endeavour would get reflected in healthier bottom lines. The degree of current assets that a company employs for achieving a desired level of sales is manifested in working capital policy. In practice, the business concerns follow three forms of working capital policies which are discussed in brief as follows: It involves the rigid estimation of working capital to the requirements of the concern and then forcing it to adhere to the estimate. Deviations from the estimate are not allowed and the estimate will not provide for any contingencies or for any unexpected events. It involves the allowing of sufficient cushion for fluctuations in funds requirement for financing various items of working capital. The estimate is made after taking into account the provision for contingencies and unexpected events. The working capital level estimated in between the two extremes i. The relationship of sales and corresponding levels of investment in current assets is shown in figure Under this policy the company maintains lower investments in current assets represent aggressive approach, intend to yield high return and accepting higher risk. The management is ready to counter any financial difficulties arising out of restricted policy. This policy represents conservative approach. It allows the company to have sufficient cushion for uncertainties, contingencies, seasonal fluctuations, changes in activity levels, changes in sales etc. The level of investment in current assets is high, which results in lesser return, but the risk level is also reduced. With this policy, the expected profitability and risk levels fall between relaxed policy and restricted policy. The higher the level of investment in current assets represents the liberal working capital policy, in which the risk level is less and also the marginal return is also lesser. In restricted policy the level of investment in current assets is lesser and high risk is perceived for increase of marginal return on investment. The determination of level of investment in currents is dependant on risk-return perception of the management. The financing pattern, current ratio, profitability net working capital position is explained under conservative, moderate and aggressive working capital policies are explained by way of hypothetical figures as follows: Page 8

9 Chapter 6 : Working Capital Management, Credit and Policies Working capital financing policy basically deals with the sources and the amount of working capital that a company should maintain. A firm is not only concerned about the amount of current assets but also about the proportions of short-term and long-term sources for financing the current assets. The company has been in business since, mainly supplying private label merchandise to large department stores. Most of its sales were negotiated directly with department store buyers, and resulting contracts contained specific credit terms. The new line, however, represents a significant change. It is sold through numerous wholesalers under standard credit terms, so credit policy per se has become important. Thus, wholsalers buying from Toddlers receive a 2 percent discount off the gross purchase price if they pay within ten days, while customers who do not take the discount must pay the full amount within 30 days. The company does check the financial strength of financial of potential customers, but its standards for granting credit are not high. Similarly, it does have procedures for collecting past-due accounts, but its collections policy could best be described as passive. Hardin must make an analysis and then recommend a course of action. Also, under the new policy stricter credit standards would be applied, and a tougher collection policy would be enforced. Langly likes this policy. Arnold Quayle, the sales manager, has argued for an easier credit policy. Quayle thinks that the proposed change would result in a drastic loss of sales and profits. Further, Langly is convinced that neither the variable cost ratio nor the cost of capital would change as a result of a credit policy change. Arnold Quayle, however, thinks that the variable cost ratio might increase significantly if sales rise so much that the company is forced to use outside suppliers. Everyone agrees that there is little chance that costs will decline, regardless of the credit policy decision. She and Langly are very much concerned about the analysis, both because of the importance to the company and also because of its "political implications". The sales and production people have been lobbying against any credit tightening because they do not want to take a chance on losing sales and having to cut production, and also because they question the assumptions Langly wants to use. Therefore, Hardin knows that her report will be critically reviewed and a thorough analysis is required. She is especially concerned about being prepared for follow-up questions that other people, such as those in sales and production, might ask when the report is being reviewed. The report should consider all relevant factors, including an analysis of both the current and proposed credit policies and a recommendation as to what Toddlers should do. Hardin has requested that you assist with the report. She is not certain what risks are involved with a credit policy change or if such risks can even be assessed and incorporated in the analysis. Thus, Toddlers would have a new credit policy without any change in sales. As with every report presented to management, there probably will be a number of questions regarding the assumptions used in the analysis. Specifically, Hardin expects both the sales and production managers to questions the assumptions, so she would like to know which variables are most critical in the sense that profitability is very sensitive to them. No one has yet determined just how far off the assumptions could be before the change to a tighter credit policy would be incorrect. However, she is not sure whether any additional actions could be taken to improve the accuracy of the forecasts. Ivana who also sits on the Board of Face Cosmetics, Inc. The decisions made by Face were always successful from a profitability standpoint. Thus, Ivana suggests that Toddlers use the same algebraic approach used by Face, in addition to constructing projected profit statements. Ivana is a very influential member of the board, so be prepared to address her suggestion. Working with Langly, she prepared the following set of questions for use as a guide in drafting her report. Put yourself in her position and answer the following questions. As you answer each question, think about follow-up questions that other people, such as those in sales and production, might ask when the report is being reviewed. Please see attachment for the remaining question. Page 9

10 Chapter 7 : Why working capital management matters Investopedia The financing pattern, current ratio, profitability net working capital position is explained under conservative, moderate and aggressive working capital policies are explained by way of hypothetical figures as follows. Working capital financing policy basically deals with the sources and the amount of working capital that a company should maintain. A firm is not only concerned about the amount of current assets but also about the proportions of short-term and long-term sources for financing the current assets. There are several working capital investment policies a firm may adopt after taking into account the variability of its cash inflows and outflows and the level of risk. One of the policies by which a firm finances its working capital needs is the hedging policy, also known as matching policy. This policy works in an arrangement where the current assets of the business are used perfectly to match the current liabilities. As per this approach, fixed and permanent current assets are financed through long-term sources and fluctuating current assets are financed through short-term sources. This policy is a medium risk proposition and requires a good amount of attention. For example, if a bank loan is due to be paid after six months, the company will ensure that sufficient amount of cash will be available to repay the loan on the date of maturity even though it may or may not currently have sufficient cash. In case of a growth firm, the amount of fixed assets and permanent current asset go on increasing with the passage of time but the volume of fluctuating current assets change with the change in production level. Fluctuating current assets, which are shown by the curved Line C, should be financed through short term sources. As the name suggests, this policy tries to avoid the risk involved in financing of current assets. Here, relatively high proportions of long-term sources are to be used for financing current assets. The firm not only matches the current assets with current liabilities but also keeps some excess amount to meet any uncertainty. Hence it cuts down the expected returns of the shareholders. This policy is illustrated in Figure 8. Line A denotes the fixed assets and Line B denotes the permanent working capital, which is financed through long-term sources. Certain portion of fluctuating current assets, which is shown by dashed Line C, is also financed by long-term sources. Under this policy some part of fluctuating current assets is financed through short-term sources. Fluctuating as well as permanent current assets under this policy will be financed through short-term debt. In this policy debt is collected on time and payments to the creditors are made as late as possible. This policy has been illustrated in Figure 8. The remaining part of permanent current assets, depicted by Line C, and the entire amount of fluctuating current assets, shown by the curved Line D, are financed by short-term debt. This is a highly risky policy for financing the working capital. As per this policy, even some part of fixed assets is financed through short-term sources. Excessive reliance on short-term sources makes this policy highly risky. A major proportion of fixed assets as shown by dotted Line A are financed through long-term sources and the remaining part of the fixed assets are financed by short-term sourcesâ shown by Line B. Short-term sources are also used for financing permanent current assetsâ Line C; as well as fluctuating current assets as shown by the curved Line D. Page 10

11 Chapter 8 : Working Capital Investment Policies (Explained With Diagram) Working capital accounting is a fairly important aspect of financial management. And, a good policy is important for the smooth functioning of the business. Simply put, working capital includes all the things you need for the process of production. Principles of Working Capital Management Policy: The following points highlight the four principles of working capital management policy. Working Capital Management Principle 1. Risk here refers to the inability of a firm to meet its obligations as and when they become due for payment. Larger investment in current assets with less dependence on short-term borrowings increases liquidity, reduces dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases the opportunity for gain or loss. On the other hand less investment in current assets with greater dependence on short-term borrowings, reduces liquidity and increases profitability. In other words, there is a definite inverse relationship between the degree of risk and profitability. A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management assumes greater risk by reducing working capital. However, the goal of the management should be to establish a suitable tradeoff between profitability and risk. The various working capital policies indicating the relationship between current assets and sales are depicted below: The effect of working capital policies on the profitability of a firm is illustrated below: Risk and Return Costs of Liquidity and Illiquidity Trade off We have discussed earlier that there is a definite inverse relationship between the degree of risk and profitability. Risk here refers to the level of current assets or the cost of liquidity. Higher the investment in current assets, higher is the cost and lower the profitability, and vice-versa. Working Capital Management Principle 2. Principle of Cost of Capital: The various sources of raising working capital finance have different cost of capital and the degree of risk involved. Generally, higher the risk lower is the cost and lower the risk higher is the cost. A sound working capital management should always try to achieve a proper balance between these two. Working Capital Management Principle 3. Principle of Equity Position: This principle is concerned with planning the total investment in current assets. Every rupee invested in the current assets should contribute to the net worth of the firm. The level of current assets may be measured with the help of two ratios: While deciding about the composition of current assets, the financial manager may consider the relevant industrial averages. Working Capital Management Principle 4. Principle of Maturity of Payment: This principle is concerned with planning the sources of finance for working capital. According to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Maturity pattern of various current obligations is an important factor in risk assumptions and risk assessments. Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater the inability to meet its obligations in time. To sum up, working capital management should be considered as an integral part of overall corporate management. To achieve the above mentioned objectives of working capital management, the financial manager has to perform the following basic functions: Estimating the working capital requirements. Financing of working capital needs. Analysis and control of working capital. Page 11

12 Chapter 9 : Good and poor working capital management policies. Working capital: Policy and Management The working capital management includes and refers to the procedures and policies required to manage the working capital. There are three types of working capital policies which a firm may adopt i.e. Moderate working capital policy Conservative working capital policy Aggressive working capital policy. Working capital management has two main decisions at two consecutive stages. They are as follows: Difference between Working Capital Policies and Working Capital Financing Strategies Commonly, policies of working capital and strategies approaches of working capital financing are interchangeably used and which is not correct. There is a thin line of difference between the two. Working capital management policy deals with the first decision and working capital management strategies or approaches deal with the second decision. Working capital policies are restricted, relaxed and moderate whereas the working capital strategies are aggressive, conservative and hedging Maturity Matching. Three Types of Working Capital Policies Based on the attitude of the finance manager towards risk, profitability and liquidity, the working capital policies can be divided into following three types. Restricted Policy In restricted policy, the estimation of current assets for achieving targeted revenue is done very aggressively without considering for any contingencies and provisions for any unforeseen event. After deciding, these policies are forcefully implemented in the organization without tolerating any deviations. In the diagram, point R represents the restricted policy which attains the same level of revenues with lowest current assets. Adopting this policy would result in an advantage of the lower working capital requirement due to the lower level of current assets. This saves the interest cost to the company and which in turn produces higher profitability i. On the other hand, there is the disadvantage in the form of high risk due to very aggressive policy. That is why; it is also called as aggressive working capital policy. Relaxed Policy Relaxed policy is just the opposite of restricted policy. In this policy, the estimation of current assets for achieving the targeted revenue is prepared after careful consideration of uncertain events such as seasonal fluctuations, a sudden change in the level of activities or sales etc. After the reasonable estimates also, a cushion to avoid any unforeseen circumstances is left to avoid the maximum possible risk. In the diagram, it represents the point Rx which uses the highest level of current assets for achieving the same level of sales. The companies having relaxed working capital policies assume an advantage of almost no risk or low risk. This policy guarantees the entrepreneur of the smooth functioning of the operating cycle. We know that earnings are more important than higher earnings. On the other hand, there is a disadvantage of lower return on investment because higher investment in the current assets attracts higher interest cost which in turn reduces profitability. Because of its conservative nature, this policy is also called as conservative working capital policy. Moderate Policy Moderate policy is a balance between the two policies i. It assumes characteristics of the both the policies. To strike a balance, moderate policy assumes risk which is lower than restricted and higher than conservative. In profitability front also, it lies between the two. The biggest benefit of this policy is that it has reasonable assurance of smooth operation of working operating capital cycle with moderate profitability. Working capital policies can be further framed for each component of net working capital i. Cash policies can be to maintain an appropriate level of cash. When the level is high, it should be invested in liquid investments for short term and vice versa. Accounts receivable policy may state about payment terms, credit period, credit limit, etc. Inventory policy may speak of minimizing the levels of inventory till the point it poses any risk to the satisfaction of customer demands. Accounts payable policies include policies of payment terms, quality terms, return policies, etc. Page 12