Riim
ARihAnt GRoup of instituion
Induction project report- Batch
2023-25
A project report on
Working Capital Management
Under The Guidence of
Submitted by
Acknowledgement
In the accomplishment of this project successfully, many people have best owned
upon me their blessing and the heart pledge support, this time I am utilizing to
thank all the people who have been concerned with his project.
Primarily I would thank god for being able to complete this project with success.
Then I would like to thank my mentor professor Dr.Bhagyashree Patil. whose
valuable guidance has been the ones that helped me patch this project and make it
full proof success. His suggestions and his instructions have served as the major
contributor towards the completions of the project.
Then I would like to thank my parents and friend who have helped me with their
valuable suggestion and guidance has been very helpful in various phases of the
completion of the project.
Last but not the least I would like to thank my classmates who have helped me a
lot.
Index
1. 1. Working Capital Management
2. 2. Why working capital management is
3. Important
4. 3. How to Minimize working Capital
4. Working Capital Management Ratios
5. Current Ratio
6. Inventory Turnover Ratio
7. Types of working capital management
8. Factors of working capital management
9. The bottom line
Working Capital Management
Introduction: Working capital management is the actions
taken to maintain a sufficient amount of working capital to
support a business, while minimizing the investment in this
area. The core goal in working capital management is to ensure
that there is always sufficient cash on hand to pay for liabilities
as they come due for payment.
Working capital management is the actions taken to maintain a
sufficient amount of working capital to support a business,
while minimizing the investment in this area. The core goal in
working capital management is to ensure that there is always
sufficient cash on hand to pay for liabilities as they come due
for payment.
Working capital management helps maintain the smooth operation of
the net operating cycle, also known as the cash conversion cycle (CCC)
—the minimum amount of time required to convert net current assets
and liabilities into cash. The working capital cycle is a measure of the
time it takes for a company to convert its current assets into cash.
Liquidity
Management
Accounts Receivables
Management
Inventory
Working Capital
Management
Management
Accounts payable
Management
Short term-Debt
Management
Understanding Working Capital
Working capital is the difference between a company’s current
assets and its current liabilities.
Current assets include cash, accounts receivable, and
inventories.
Current liabilities include accounts payable, short-term
borrowings, and accrued liabilities.
Some approaches may subtract cash from current assets and
financial debt from current liabilities.
Why Working Capital Management is Important
Ensuring that the company possesses appropriate resources for
its daily activities means protecting the company’s existence
and ensuring it can keep operating as a going concern. Scarce
availability of cash, uncontrolled commercial credit policies, or
limited access to short-term financing can lead to the need for
restructuring, asset sales, and even liquidation of the company.
How to Minimize Working Capital
There are many ways to reduce a company’s investment in
working capital. Consider the options noted below.
Alter Policy Decisions
Some management decisions can have a direct impact on the
level of working capital. For example, offering customers
excessive credit in order to generate more sales represents a
cash investment in accounts receivable. Or, setting a 24-hour
order fulfillment policy will require a business to maintain much
higher inventory levels than usual, which also requires a cash
investment. These investments can be altered by adjusting the
underlying policies.
Require Customer Deposits
In cases where customized goods are being produced, require
customers to pay the full amount of the billing before work
begins. Doing so is reasonable, since the company cannot sell
the goods anywhere else. This policy also eliminates the
investment in accounts receivable.
Shorten Customer Payment Terms
Reduce the number of days that customers are allowed to wait
before paying an invoice. While this approach can reduce the
investment in receivables, it is hard to enforce and may drive
customers toward competitors who offer more generous terms.
Tighten Credit
Impose a tougher review process on requests from customers
for trade credit. Doing so will likely result in some low-quality
customers being denied credit, but it will reduce the number of
customers who are likely to pay late.
Monitor Inventory Usage Levels
Routinely compare on-hand inventory balances to usage levels,
to see if there is any excess inventory on hand. If so, and there
is no immediate prospect for selling the excess amounts, then
several actions can be taken to dispose of it. One is to return it
to suppliers, perhaps in exchange for paying a restocking fee.
Another option is to offer customers a special deal on these
items, to encourage their immediate sale. Yet another
possibility is to immediately sell it off to a discounter at a deeply
reduced price. These actions can quickly turn excess inventory
into cash.
Avoid Early Supplier Payments
Closely monitor when payments are issued to suppliers, to
ensure that payments are not made early. This can happen
when invoice dates are incorrectly entered into the accounting
system, or when suppliers pressure the payable staff to send
them payments before the company is contractually obligated
to do so.
Lengthen Supplier Payment Terms
Negotiate with suppliers to lengthen payment terms. Doing so
delays the outflow of cash needed to pay for supplier invoices,
which represents a source of cash. Do not unilaterally impose
longer payment terms on suppliers, since this can annoy them
to the point where they may no longer accept orders without
an up-front payment.
Working Capital Management Ratios
Several ratios are available that can assist managers in
overseeing working capital. They are the days sales outstanding,
current ratio, and inventory turnover ratio. We explore all three
measurements below.
Days Sales Outstanding
Days sales outstanding is used to determine the efficiency with
which a business collects its accounts receivable. The formula is
to divide accounts receivable by the annual revenue figure and
then multiply the result by the number of days in the year. The
formula is as follows:
(Accounts receivable ÷ Annual revenue) × Number of days in
the year = Days sales outstanding
The outcome is really a function of not just how well the
collections staff does its job, but also of how well the credit staff
advances credit to customers. If the credit staff erroneously
grants credit and the company is not paid, then the DSO figure
can be quite long.
Current Ratio
One of the essential working capital measurements is the
current ratio, which compares current assets to current
liabilities. If the current assets figure is substantially higher than
current liabilities, then a business should be able to settle its
short-term obligations in a timely manner. A ratio of at least 2.0
is considered to be quite good.
A problem with the current ratio is that the inventory
component can be quite difficult to liquidate. Therefore, if the
inventory component comprises a large proportion of current
assets, it is quite possible that a business will have a hard time
settling its obligations on time, because it cannot come up with
the necessary cash on short notice.
Inventory Turnover Ratio
An additional working capital measurement is the inventory
turnover ratio. Inventory turns should be quite high, which
means that a business can sell off its inventory within a short
period of time. When this is not the case, inventory may
become a liability, since it sequesters cash and may result in
obsolete inventory write-offs.
Inventory turnover is calculated by dividing the cost of goods
sold for the year by ending inventory. The cost of goods sold
figure is used instead of sales, because the sales figure includes
a markup that is irrelevant to the calculation, and artificially
inflates the turnover figure. The formula is as follows:
Annual cost of goods sold ÷ Ending inventory = Inventory
turnover
An excessively high inventory turnover ratio can indicate that a
business does not have sufficient cash to pay for the inventory
needed to run its operations. When this is the case, the firm will
probably not be able to maximize its sales.
Factors That Affect Working Capital Needs
Working capital needs are not the same for every company. The
factors that can affect working capital needs can be endogenous
or exogenous.
Endogenous factors include a company’s size, structure, and
strategy.
Exogenous factors include the access and availability of banking
services, level of interest rates, type of industry and products or
services sold, macroeconomic conditions, and the size, number,
and strategy of the company’s competitors.
Managing Liquidity
Properly managing liquidity ensures that the company
possesses enough cash resources for its ordinary business
needs and unexpected needs of a reasonable amount. It’s also
important because it affects a company’s creditworthiness,
which can contribute to determining a business’s success or
failure.
The lower a company’s liquidity, the more likely it is going to
face financial distress, other conditions being equal.
However, too much cash parked in low- or non-earning assets
may reflect a poor allocation of resources.
Proper liquidity management is manifested at an appropriate
level of cash and/or in the ability of an organization to quickly
and efficiently generate cash resources to finance its business
needs.
Managing Accounts Receivables
A company should grant its customers the proper flexibility or
level of commercial credit while making sure that the right
amounts of cash flow in via operations.
A company will determine the credit terms to offer based on
the financial strength of the customer, the industry’s policies,
and the competitors’ actual policies.
Credit terms can be ordinary, which means the customer
generally is given a set number of days to pay the invoice
(generally between 30 and 90). The company’s policies and
manager’s discretion can determine whether different terms
are necessary, such as cash before delivery, cash on delivery,
bill-to-bill, or periodic billing.
Managing Inventory
Inventory management aims to make sure that the company
keeps an adequate level of inventory to deal with ordinary
operations and fluctuations in demand without investing too
much capital in the asset.
An excessive level of inventory means that an excessive amount
of capital is tied to it. It also increases the risk of unsold
inventory and potential obsolescence eroding the value of
inventory.
A shortage of inventory should also be avoided, as it would
determine lost sales for the company.
Managing Short-Term Debt
Like liquidity management, managing short-term financing
should also focus on making sure that the company possesses
enough liquidity to finance short-term operations without
taking on excessive risk.
The proper management of short-term financing involves the
selection of the right financing instruments and the sizing of the
funds accessed via each instrument. Popular sources of
financing include regular credit lines, uncommitted lines,
revolving credit agreements, collateralized loans, discounted
receivables, and factoring.
A company should ensure there will be enough access to
liquidity to deal with peak cash needs. For example, a company
can set up a revolving credit agreement well above ordinary
needs to deal with unexpected cash needs.
Managing Accounts Payable
Accounts payable arises from trade credit granted by a
company’s suppliers, mostly as part of the normal operations.
The right balance between early payments and commercial
debt should be achieved.
Early payments may unnecessarily reduce the liquidity
available, which can be put to use in more productive ways.
Late payments may erode the company’s reputation and
commercial relationships, while a high level of commercial debt
could reduce its creditworthiness.
Accounts Payable vs Accounts Receivable
In accounting, confusion sometimes arises when working
between accounts payable vs accounts receivable. The two
types of accounts are very similar in the way they are recorded,
but it is important to differentiate between accounts payable vs
accounts receivable because one of them is an asset account
and the other is a liability account. Mixing the two up can result
in a lack of balance in your accounting equation, which carries
over into your basic financial statements.
It is important to note the significance of balancing your assets
and liabilities and stockholders’ equity in accounting. The
significance of the balance can be explained by the basic
accounting equation: Assets = Liabilities + Stockholders’ Equity.
One can also rearrange the equation to better suit their
preferences.
What are Accounts Payable?
Accounts payable is a current liability account that keeps track
of money that you owe to any third party. The third parties can
be banks, companies, or even someone who you borrowed
money from. One common example of accounts payable are
purchases made for goods or services from other companies.
Depending on the terms for repayment, the amounts are
typically due immediately or within a short period of time.
What are Accounts Receivable?
Accounts receivable is a current asset account that keeps track
of money that third parties owe to you. Again, these third
parties can be banks, companies, or even people who borrowed
money from you. One common example is the amount owed to
you for goods sold or services your company provides to
generate revenue.
How to Record Accounts Payable?
In business transactions, companies will often purchase items on
account (not for cash). The term used to call the transactions is
purchases “on account,” which signifies a transaction where cash is not
involved. The best way to illustrate this is through an example.
On June 1, 2017, Corporate Finance Institute purchased $1,000 worth of
computer equipment on account from LED Company. It means our asset
account, computer equipment, increased and our liability account,
accounts payable, also increased by $1,000. Below is what it would look
like in a journal entry:
How to Record Accounts Receivables?
On the other hand, there are times when a company will sell goods or
services “on account.” Again, it means that there is a transaction
occurring where cash is not involved. Here is another example to help
illustrate what this might look like.
On June 2, 2017, Corporate Finance Institute sold $300 worth of office
supplies on account to Price Company. In the transaction, our accounts
receivables increased by $300 and our office supplies account
decreased by $300. This is what it would look like in a journal entry:
Discounts on Accounts Payable vs Accounts Receivable
Another important note to make is that sometimes companies will
attach discounts to their account receivable accounts to incentivize the
borrower to pay back the amount earlier. The discounts benefit both
parties because the borrower receives their discount while the
company receives their cash repayment sooner, as companies require
cash for their operating activities.
Notations for Discounts
Here are two notations that are commonly used:
1. x/10 or x/20 (where “x” is usually any number between 1 and 4)
2. n/30
For the first notation, we read it as an “x” percentage discount if the
amount is paid back or received within 10 days. Some companies may
choose to even give a discount if the amount is paid back or received
within 20 days. Here is what an example of a 4% discount, if paid back
within 15 days, would look like: 4/15.
The second notation, usually used after the discount notation, means
the net amount must be paid within 30 days or how many days you
decide. A perfect way to demonstrate what this would mean is to show
an example.
Example of Accounts Payable
On March 31, 2017, Corporate Finance Institute decided to purchase
$750 worth of inventory on account from FO Supplies. The terms of this
transaction were 2/10, n/30. This is what it would look like in the
journal entry:
This is what the initial purchase of inventory would look like in the
journal entry. We excluded the terms in the description portion of our
journal entry because it is optional. It is up to the individual whether or
not they wish to include the terms of the transaction.
The next part is recording the discount if the account is paid back within
the discount period. In order to determine the discount, we need to
take the $750 and multiply by 0.02 (2%). This is what it would look like
in your journal entry:
Example of Accounts Receivable
Here we will use the same example as above but instead, Corporate
Finance Institute sells $750 worth of inventory to FO Supplies. The
terms are still the same, at 2/10, n/30.
This is the first entry that an accountant would record to identify a sale
on account. Afterward, if the receivables are paid back within the
discount period, we need to record the discount.
What is Working Capital vs Investing Capital?
In the performance of their duties, financial analysts often need to
distinguish between working capital vs investing capital. Working
capital, also referred to as net-working capital or NWC, represents the
difference between an organization’s current assets (e.g., cash,
inventory, accounts receivable) and its current liabilities (e.g., accounts
payable). Working capital serves as a measure of a company’s liquidity.
On the other hand, investing capital is an amount of money given to an
organization to achieve its business objectives. The term also refers to
the acquisition of tangible long-term assets, such as manufacturing
plants, real estate, and machinery.
Summary
• Working capital (WC) is represented as the difference between an
organization’s current assets (e.g., cash, inventories of raw
materials and finished goods, accounts receivable) and its current
liabilities (e.g., accounts payable).
• Current assets include cash, inventory, accounts receivable, and
other assets that are expected to be turned into cash or liquidated
in less than a year.
• Current liabilities contain taxes payable, accounts payable, wages,
and the current portion of long-term debt.
What is Working Capital?
Working capital measures a business’s operational efficiency, liquidity,
and financial health in the short term. If a company shows enough
positive working capital, then it can potentially grow and invest, using
the capital at its disposal. If an organization’s current assets are less
than its current liabilities, it may encounter challenges to pay back
creditors or expand the business. Also, the company can even go
bankrupt.
As mentioned earlier, the working capital is calculated by taking the
company’s current assets and subtracting its current liabilities. Current
assets are assets that are expected to be turned into cash or liquidated
in less than a year. Current liabilities are also due within twelve months.
Most major projects, such as expansion into new markets or in
production, require a working capital investment. It reduces the
company’s cash flow. Nevertheless, the cash level will also decrease if
sales volumes are decreasing or money is being collected very slowly,
which leads to a similar decline in accounts receivable.
What is Investing Capital?
The investing capital term is broadly used and can be defined in two
different ways:
• An individual, a financial institution, or a venture capital group can
make a capital investment in a company. A sum of money is
provided in return for its repayment promise or profit shares
down the road, or as a loan. In this context, capital is referred to
as cash.
• Company executives can make a capital investment in the
business. They acquire long-term assets that will help the business
expand faster or run more efficiently. In this context, capital refers
to physical assets.
In both cases, the money for investment capital must be provided from
somewhere. A new enterprise may seek investing capital from different
sources, including angel investors, venture capital firms, and regular
financial institutions. The capital will be further utilized to develop and
market its products. When a new enterprise goes public, it is obtaining
investing capital on a large scale from various investors.
An established organization may make a capital investment by seeking a
loan from a bank or using its cash reserves. If it is a public company, it
can consider issuing bonds to finance investing capital.
A decision by a company to make a capital investment is related to its
long-term growth strategy. Investing capital is generally made to occupy
a larger share in the market, increase operational capacity, and
generate more revenues. The organization may make the investing
capital in the form of an equity stake in another organization’s
complementary operations for the same goals.
To measure whether the success of a capital investment, the return on
invested capital ratio (ROIC) is used. The higher the ROIC is, the more a
company profits on the amount initially invested. The formula for ROIC
is given below:
If ROIC is more than the company’s WACC, then it creates value for its
shareholders because it earns more than it borrows.
Types of Working Capital
In its simplest form, working capital is just the difference between
current assets and current liabilities. However, there are many different
types of working capital that each may be important to a company to
best understand its short-term needs.
• Permanent Working Capital: Permanent working capital is the
amount of resources the company will always need to operate its
business without interruption. This is the minimum amount of
short-term resources vital to operations.
• Regular Working Capital: Regular working capital is a component
of permanent working capital. It is the part of the permanent
working capital that is actually required for day-to-
day operations and makes up the "most important" part of
permanent working capital.
• Reserve Working Capital: Reserve working capital is the other
component of permanent working capital. Companies may require
an additional amount of working capital on hand for emergencies,
seasonality, or unpredictable events.
• Fluctuating Working Capital: Companies may be interested in only
knowing what their variable working capital is. For example,
companies may opt into paying for inventory as it is a variable
cost. However, the company may have a monthly liability relating
to insurance it does not have the option to decline. Fluctuating
working capital only considers the variable liabilities the company
has complete control over.
• Gross Working Capital: Gross working capital is simply the total
amount of current assets of a business before considering any
short-term liabilities.
• Net Working Capital: Net working capital is the difference
between current assets and current liabilities.
Why Manage Working Capital?
Working capital management can improve a company's cash flow
management and earnings quality through the efficient use of its
resources. Management of working capital includes inventory
management as well as management of accounts receivable
and accounts payable.
Working capital management also involves the timing of accounts
payable (i.e., paying suppliers). A company can conserve cash by
choosing to stretch the payment of suppliers and to make the most of
available credit or may spend cash by purchasing using cash—these
choices also affect working capital management.
The objectives of working capital management, in addition to ensuring
that the company has enough cash to cover its expenses and debt, are
minimizing the cost of money spent on working capital, and maximizing
the return on asset investments
Working Capital Cycle
In addition to the ratios discussed above, companies may rely on the
working capital cycle when managing working capital. Working capital
management helps maintain the smooth operation of the net operating
cycle, also known as the cash conversion cycle (CCC)—the minimum
amount of time required to convert net current assets and liabilities
into cash. The working capital cycle is a measure of the time it takes for
a company to convert its current assets into cash, or:
Working Capital Cycle in Days = Inventory Cycle +
Receivable Cycle - Payable Cycle
The working capital cycle represents the period measured in days from
the time when the company pays for raw materials or inventory to the
time when it receives payment for the products or services it sells.
During this period, the company's resources may be tied up in
obligations or pending liquidation to cash.
Inventory Cycle
The inventory cycle represents the time it takes for a company to
acquire raw materials or inventory, convert them into finished goods,
and store them until they are sold. During this stage, the company's
cash is tied up in inventory. Though it starts the cycle with cash on hand,
the company agrees to part ways with working capital with the
expectation that it will receive more working capital in the future by
selling the product at a profit.
Accounts Payable Cycle
The accounts payable cycle represents the time it takes for a company
to pay its suppliers for goods or services received. During this stage, the
company's cash is tied up in accounts payable. On the positive side, this
represents a short-term loan from a supplier meaning the company is
able to hold onto cash even though they have received a good. On the
negative side, this creates a liability that needs to be managed.
Limitations of Working Capital Management
With strong working capital management, a company should be able to
ensure it has enough capital on hands to operate and grow. However,
there are downsides to the approach. Working capital management
only focuses on short-term assets and liabilities. It does not address the
long-term financial health of the company and may sacrifice the best
long-term solution in favor for short-term benefits.
Even with the best practices in place, working capital management
cannot guarantee success. The future is uncertain, and it's challenging
to predict how market conditions will affect a company's working
capital. Whether its changes in macroeconomic conditions, customer
behavior, and supply chain disruptions, a company's forecast of working
capital may simply not materialize as they expected.
Last, while effective working capital management can help a company
avoid financial difficulties, it may not necessarily lead to increased
profitability. Working capital management does not inherently increase
profitability, make products more desirable, or increase a company's
market position. Companies still need to focus on sales growth, cost
control, and other measures to improve their bottom line. As that
bottom line improves, working capital management can simply enhance
the company's position
The Bottom Line
Working capital management is at the core of operating a business.
Without sufficient capital on hand, a company is unable to pay its bill,
process payroll, or invest in growth. Companies can better
understanding their working capital structure by analyzing liquidity
ratios and ensuring its short-term cash needs are always met.
