Working Capital Management: Meaning, Cycle & Financing
What is Working Capital Management? (Concept & Meaning)
Working Capital Management is the functional area of finance that deals with a firm’s current assets and current liabilities. It ensures the company has sufficient liquidity to run day-to-day operations while maximizing profitability.
Working Capital refers to funds invested in current assets like raw materials, work-in-progress, finished goods, debtors, and cash.
Two Concepts of Working Capital:
Gross Working Capital: The total investment in all current assets.
Net Working Capital: The excess of total current assets over total current liabilities.
Formula:
Net Working Capital = Current Assets - Current Liabilities
Types based on Time:
Permanent (Hard Core) Working Capital: The minimum level of current assets required at all times to carry out business. It should ideally be financed by long-term sources.
Temporary (Variable) Working Capital: The additional capital required over and above the permanent level to meet fluctuating demands (e.g., seasonal spikes).
The Working Capital Cycle (Operating Cycle)
The Operating Cycle refers to the length of time from the purchase of raw materials to the realization of cash from sales. It represents the time funds are tied up in the business process.
Formula: Operating Cycle = R + W + F + D - C
R = Raw Material Storage Period
W = Work-in-Progress Holding Period
F = Finished Goods Storage Period
D = Debtors Collection Period
C = Credit Period from Suppliers
Note: A shorter operating cycle means the firm needs less working capital because cash is recovered quickly. A longer cycle requires more working capital.
Approaches to Financing Working Capital
How should a firm fund its working capital needs? There are three main approaches based on the risk-return trade-off.
1. Matching (Hedging) Approach
The firm matches the maturity of the source of funds with the life of the asset.
Long-term sources finance Fixed Assets + Permanent Working Capital.
Short-term sources finance Temporary Working Capital.
Risk/Return: Moderate.
2. Conservative Approach
The firm relies more on long-term funds to be safe.
Long-term sources finance Fixed Assets + Permanent Working Capital + Part of Temporary Working Capital.
Short-term sources finance only the remaining peak temporary needs.
Risk/Return: Low Risk (high liquidity), but Lower Return (since long-term funds are costlier).
3. Aggressive Approach
The firm relies heavily on short-term funds to save costs.
Short-term sources finance Temporary Working Capital + Part of Permanent Working Capital.
Risk/Return: High Risk (danger of insolvency if loans aren’t renewed), but Higher Return (since short-term funds are cheaper).
Regulation of Bank Finance (Tandon Committee)
Banks are the primary source of working capital finance in India. To regulate this, the RBI set up the Tandon Committee (1974) to introduce financial discipline.
The 3 Methods of Lending (Maximum Permissible Bank Finance – MPBF):
Method 1: Bank lends 75% of the Working Capital Gap (Current Assets – Current Liabilities). The borrower provides 25% from long-term sources.
Formula:
MPBF = 0.75 (CA - CL)
Method 2: Bank lends 75% of Total Current Assets minus Current Liabilities. The borrower provides 25% of Total Current Assets.
Formula:
MPBF = (0.75 * CA) - CL
Method 3: Bank lends against “Core Current Assets.” (Rarely used).
Impact: These norms ensured that companies maintain a minimum current ratio and do not rely entirely on bank funds for their operations.
Factors Affecting Working Capital Needs
Nature of Business: Manufacturing firms need more WC than trading or service firms due to production cycles.
Production Policy: Seasonal vs. steady production affects inventory levels.
Credit Policy: Liberal credit to customers increases debtors, increasing WC needs.
Business Cycle: Booms increase demand and WC needs; recessions decrease them.
Growth & Expansion: Growing firms need more WC for larger operations.