Working capital demonstrates how much liquid asset is accessible to satisfy the short-term cash requirements obligatory by current liabilities in a business. The working capital assumes that current asset and current obligation are short-term concepts; thus, it is defined as a short-term concept. A working capital shows the efficiency and stability of the short-term financial in the business. In case the working capital is stale it shows that the business is capable of meeting its debt obligation without any difficulties. The main component of the working capital includes asset that comprises current and fixed assets and liabilities that comprises the short-term operating liabilities, long and short terms financial debt and equity. The current liabilities are also referred to as a long-term capital; therefore, working capital is usually defined as; Working Capital = Current Assets – Current Liabilities. Thus, the thesis statement of working capital will be; working capital management ensures that sufficient liquid resources are available to understand the influences and affect the developments and profitability in the business environment.
The working capital plays significant roles in the development and profitability of the businesses in the economy by reducing risks of business. Important corporations implement managing working capital because it not only protects business from recession period and non-forecast situations, but it also allows expansions when business formulate new plans strategies. The working capital gives a business a strong foundation, flexibility, and strength to undertake business opportunities in the market despite the competition.
It builds the inventories required to generate the optimum profit needed to stabilize the business from collapsing due to lack of proper management. The prospects of the business have improved gradually because working capital aid in making the fabulous ideas into reality due to, an establishment of working capital loans that do not require securities.
Therefore, working capital fulfils the expectations of business and overcome challenges to meet the business targets despite the current situations in the economy market. It maximizes the possibilities of establishing lasting and successful business ideas and measures for operational efficiency. The large number of debtors in the company indicates the company is not prepared to undertake the obligations of paying its arrears obligations. The proper management of working capital ensures the debtors get their dues on time, consequently, if a company is not operating efficiently, it will indicate working capital is low, therefore, significant problem in the company’s developments and profitability.
The business can manage the working capital properly to obtain the solution to amend the problem so that shareholders can increase their trustworthiness to the company. By managing and controlling the stocks and the financial situations that lead to significant performance of the company Stock ownership. The working capital gives the employees financial rewards during the profitability period of the business. Afza and Nazir (2008) demonstrated that if the company has a negative, working capital it shows, debtors use excessive credit transfer facilities in the company and the firms borrow high amount of loans to manage the business. This will lead business into problems with debt collection or the financial position of significant customers, and management of the business should control the problem to avoid the dissolution. In conclusion, the working capital is hugely significant in business, and it improves the development and the profitability of the business in the market.
The working capital management is founded on the basic balance sheet identity that consists the working capital components, written as (Carole, 2003).
Networking capital (cash + other current asset)-current asset) + fixed asset =long-term debt equity. Alternatively, cash may follow:
- Cash =Long term +Equity + current liabilities- Current assets other than cash – Fixed assets.
The increased need for cash in the business finances long-term debt of the company, and it consider raising long-term loan from banks to fund the intended investment to expand the profits of the company. Meanwhile, the business should consider increasing its equity by issuing shares to increase capital that will help to manage the working capital effectively; the additional costs related to such method are reduced due to proper management of capital. The company may increase its current liabilities management by negotiation of long credit periods from its general creditors, to increase the payable periods. Such management methods are dependent on the operating cycles of its creditors. Besides, such negotiation depends on the bargaining power of the business and during adverse scenario may destroy the business relationship between the company and its suppliers in the process of management.
The company may decrease its current assets other than cash, for instances the company may consider selling some inventories for cash by promotion. Chiou et al (2006, 149-155) state that the company may further reduce the inventories period by adopting Economic Order Quantity model (EOQ) or Just in Time (JIT) techniques used in the working capital management.
The current system and the purchase cycle of the company have to determine the optimum quantity ordered for EOQ techniques in working capital management. Finally, the business may decrease its fixed assets because there may be certain plant or equipments that are obsolete or no longer required by the company for business production. Realizing such fixed assets for cash can be a means to manage the working capital in the business (Deloof, 2003).
The components of working capital are managed by use of the following methods:
- The Trade Credits
The perish ability and collateral value as well as consumer demand, are factors that influence the credit period of the company. Products that are established have more rapid turnover, costs, profitability, and standardization. Relatively, inexpensive goods tend to have shorter credit periods, risks and the greater the credit risk, the shorter the credit periods are likely to be. The size of accounts and the bigger the accounts customers the longer the credit period required for the management of the components of the working capital.
- The Trade Debt
The payable period of the long-term capital, contribute to the high and low liquidity of the company. The company finances working capital not only by short-term bank loans but also by the trade debts that have an unusually long payable period (Dev, 2003). Alternatively, in view of the high level of cash management in the company, it should consider taking any trade discount from the suppliers, if there are no existing or contemplated projects that require substantial cash (Eugene and Brigham, 2009).
- Cash Management
There are three motives for the liquidity, namely speculative, precautionary, and the transaction motives (Filbeck and Krueger, 2005). There may be additional reasons to hold sufficient cash balances at the commercial banks to compensate for the banking services that the company receives. The company may require cash for working capital management activities and need cash for possible expenditures, such as acquiring other business.
- Cash operating cycle management
Cash operating shows the parameters used to measure the management performance of the company. The receivables and payable in the operating cycle show how the company manages decisive operational, capital assets. The average cash operating cycle of the company is demonstrated in the following formula (Eljelly, 2004).
Cash cycle = operating cycle (inventory period + Accounts receivable period) – Accounts payable period. Therefore, the company should manage and control the inventories of the company well to expand its operations in the market niche.
Management of stocks and other financial instruments Filbeck et al (2007) on their research demonstrated that shareholders increase their trustworthiness to the company manages; control the stocks and the financial situations. The business should improve the international operations, to face the foreign exchange exposure, including transaction and translation exposure. It helps the company to monitor its total foreign currency exposure centrally to net off affiliate positions and hedge transactions with the banks. The company is capable to protect the anticipated foreign currency revenue with appropriate foreign exchange contracts; hence, the company is capable of managing the components of working capital through the foreign sources.
Working capital management techniques used by business helps in efficiently management of working capital. Working capital management means managing current assets and working capital management techniques are very effectual tools.
Working Capital = Current Assets – Current Liabilities. The business focuses on current assets because they forecast the current liabilities, therefore, controlling the current assets can as while controlling the current liabilities. The following are the working capital technique that manages different components of working capital.
The inventory Management Techniques
During the recession and tight money periods the business has to be flexible in the inventory management for instance the quantity to be ordered may need to be adjusted to reflect the increase costs.
The way to manage the inventories
Garcia and Martinez (2007, pp164-177) state that inventory costs comprise ordering costs and carrying costs ordering costs include the cost of placing order and receiving the goods. Examples are freight changes and clerical costs, these costs assume constants for each order, irrespective of the number of the units in the order.
Total number of orders = S/EOQ,
Where,
- S = sum usage
EOQ =economic order quantity: the maximum amount of order (ordering and carrying)
Total order costs = S/EOQ *O
Where,
- O = cost per order
Carrying the costs includes the shortage, handling, and insurance costs as well as required return rate on the inventory investment. James (2010) demonstrated the inventory technique model that assumes constant per unit of the inventory is obtained by the following equation.
Total carrying cost = EOQ/2 * C
Where.
- C = carrying cost per unit
EOQ/2 = average inventory quantity for the period.
Total inventory cost = (S/EOQ *O) + (EOQ/2 * C)
Jae and Joel (2009) show that there exists a swap between the order size and the carrying cost, the higher the order quantity (EOQ), the higher the carrying cost, the lower the ordering cost.
EOQ= square root of (2SO/C).
The Example of the EOQ Techniques
The Business is trying to determine the frequency of orders for an item from a supplier. Each item cost $ 10. Carrying cost that estimates at $200 per year. The business anticipates selling 100 units per month. Average desired inventory is 100. Order cost is $10 and the business want to know the optimum quantity and the order frequency.
EOQ= the square root of (2SO/C), the square root of {(2) (12 *100) *10}/ 2 = the square root of 12000 =109, C = Carrying cost / Average inventory, (which equals unit cost * average quantity).
200/10 * 100 =200/1000 =0.2 or 20%
C = Purchase price * percentage of carrying cost to average investment
C = $100*0.2=2
The number of orders per year = S/ EOQ= 1200/109=11(rounded)
The inventory techniques help the business to evaluate the efficiency associated with buying and controlling inventory in case there is a lack of control and the restrict inventory balances (Hrishikesh,2004). In addition, it evaluates the future trends in the product and the services prices, if the expected price increase it is good for the company to buy more resources. It also utilizes computer techniques and the operations research properly to manage the inventory of the business. The weakness of the inventory techniques is that, in case of the resources shortage on the safety of the stock balance the problem could cause the shutdowns of the business.
The Cash Models Techniques
Lorenzo and Virginia (2010) in their research demonstrated that several mathematical models have been formulated to assist the financial managers in distributing a company’s finances so that they can provide a maximum return to the company. The objective of the model is to reduce the sum of the fixed costs of the transactions and the opportunity of holding the cash balances that are non-profitable. Nazir and Afza (2008) in their work showed the cost model equation as F (T)/C + I (C)/2.
Where,
- F = the fixed cost of a transaction
- T =the total cash needed for the period involved
- I = the interest rate on the marketable securities
- C= cash balances
- The optimal level of the cash C* is determined using the following
- C* = square root of (2FT/ i)
The examples of the cash model techniques
The business estimate cash for $5000, 000 over a non-month period during which the cash accounts at a constant rate. The rate of return is 5 percent per annum and the transaction cost each time the business borrows or withdraws is $50. The optimal transaction size and the number of the transaction the business should make during the month follows:
C* = square root of (2FT/I ) = square root of the[ ( 2 * 5000000 *50)/ 0.05] = 100000
C* = $100000
C*/2 = $100000/2=500000
Therefore, $50000/500000=1 (transaction during the month).
The main weakness of the cash model techniques is that the fixed costs of the securities transaction are assumed to be the same, for buying and selling of which is not reality in the market, and the randomness of the cash flow is another weakness of the cash technique(Myers, 2007). Meanwhile, the cash model helps the managers to distribute the company’s finances so that they can provide a maximum return to the company. Michalski (2007, 42-53) states that management of the working capital consists, evaluating of various types of the current assets and current liabilities and evaluation helps in making decisions on assets finances. Working capital involves transaction between return and the risks, if the funds go from fixed assets to current assets, there is a reduction in liquidity risks, greater ability to get short term financing, and enhancing the conflicting objectives of the working capital (Mathuva, 2009).
In conclusion, financing with noncurrent debt has less risk than financing with the current debt; however, the long-term debt has a higher cost than short debt because of the greater uncertainty that detracts from overall return. When there is conflicting objective of the working capital, the business should use the hedging approach of financing where asset finances liabilities of the similar maturity. Meanwhile, the longer the period required to purchase and produce goods, working capital available to finance the situations. Finally, the company should analysis working capital to ensure gives a good result in the net saving and obtaining optimum profitability.
List of References
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