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Working Capital Management

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Executive Summary

Working capital describes the firm’s investment in the current assets financed by current liabilities. Current assets are cash, cash equivalent, inventory, and accounts receivable. In this paper, current liabilities and non-current liabilities are also discussed. Financial management of the companies prefers optimal level management for accounts receivable and cash of the company. Two important ways of financing the company’s current assets and working capital are liquidity or financing through loans and securities selling? In liquidity, companies sell out their plant and fixed assets to finance the assets side. In low liquidity, working capital face issues as the decrease in cash results in the failure to gain attractive discounts. Simultaneously, the excess of liquidity is also not good for the company and its profitability. Therefore financial managers pay importance to the management of the working capital of the company. After analyzing the whole situation, they decide whether they should take the loan on a long-term financing basis or short term returnable basis. The decision of managers towards the financing of current assets decides about the profitability of the company.   

Introduction

Working capital management is the administration and management of the current liabilities and current assets of the company. Financial managers in the companies decide about the financing strategies of the company. Three major approaches are adopted by the companies working in any field of life. Aggressive approach, conservative and hedging approach of working capital management influences the profitability of the company. The research studied the impact of these approaches on various world companies to generalize which approach is best for managing the working capital (Abor, 2016).

Financial management of the company decides how much investment is required for the company and how they will get that money. They decide whether the company has to lend loans on a long term financing basis or short term financing basis. The financial manager takes such decisions in the light of the approach they are following for the working capital management (Baños-Caballero, García-Teruel, & Martínez-Solano, 2014). 

Literature Review

            Literature is reviewed on the topic of working capital management. The literature review’s primary purpose is to collect the latest information about working capital management’s impact on the profitability and overall role of working capital in the business. Working capital management approaches and the significant importance of these approaches are also reviewed in the literature. The articles used for the literature review are based on empirical studies; therefore, these articles’ results can be generalized for all companies.

          According to the studies of Gill, Bigger, and Mathur conducted in 2010 elaborates that working capital management is included in corporate management’s fundamental duties. The top-level magnet in an organization develop strategies that ensure the increase in the shareholders’ equity and value. For this purpose, they develop strategies for working capital management.  (Gill, Biger, & Mathur, 2010) Shareholders value increases when the capital management works according to the optimal level strategy.

The optimal level strategy supports the management to maintain an appropriate level of current assets in the business. The optimal level is the state between the inadequacy and excessiveness of the current assets that influence its liquidity. According to the literature review, each company has two factors as liquidity and solvency that determine its success in the operations (Gill, Biger, & Mathur, 2010). Liquidity is to finance the assets by selling the fixed and plant assets of the company. At the same time, financing through debt is relatively similar to the approach of solvency. Because of this in financial management, we call the asset side the investment side, and the equity side are known as financing sides for the investment.     

           Studies also explain that companies cannot keep a high level of current assets. In the modern world, the expense is diverse and unpredictable. Uncertainty in the market is the fact that managers cannot ignore to run a business successfully. Fluctuating current assets directly influences the overall profitability of the company (Afza & Nazir, 2007). When current assets touch the minimum limit, it starts alerting the management about the company’s possible issue as a decrease in the capability to pay back the short term loans and funds to the creditors. Companies take more loans and funds from the external environment; thus, liability also goes up.

The primary purpose of the management of working capital is to maintain the optimal level in the business. To increase business profitability, managers may focus on managing the receivable, payable, and inventory with its cash assets. Financing the current assets with short-term funds and loans is beneficial for the company as if they use long-term debt to finance the current assets, they will have to pay more interest on the debt. Interest expense reduces the company’s profitability as it increases the overall expense (Mathuva, 2010).

In Gill, Bigger, and Mathur’s research studies, 208 companies are used as the research study sample. Findings indicate a negative relationship between profitability and aggressive working capital management (Nazir & Afza, 2009). The aggressive approach increased the short-term debt, reducing the business’s efficiency after completing the business cycle; they pay back short-term debt from the business’s cash. Cash transaction reduces the overall profit of the company and the capability to run further operations.

Under the research of Afza & Nazir, corporate finance focuses on long-term financing decisions and investment. Corporate level strategies and decisions increase or decrease the business’s value in the market and change the amount of dividend. Companies take investment from the external environment to run the operations of the company smoothly. For this purpose, they offer securities, bonds, and shares of the company for long term financing. While the financing is concerned with the short-term loans, the company takes loan and credit from the market to promise to payback on the maturity date (before the passage of one year).

There are two significant types of working capital management issues concerned with the optimal current assets level under the literature review. The first issue is when the liquidity is inadequate or low and when excessive or high liquidity. In the case of inadequate cash, inventory, and receivables (or in short, low liquidity), companies face issues as a decrease in the company’s worth and value (Nazir & Afza, 2009). Creditors offer credit to the companies that can pay back the loan or credit amount on the due dates. Companies that have low cash and liquidity ratios face failure to gain attractive discounts.

Low inventory results in the loss of sales and downfalls. At the same time, excessive inventory increases the carrying cost and storage cost. According to the research, management keeps the inventory in the warehouse that increases the business’s expense. Fixed asset costs can be reduced by leasing or selling the fixed assets in the open market if a company needs immediate cash. But in the current assets, companies cannot sell out or lease current assets. Therefore companies pay attention to the large extent of the current assets management and working capital management. 

According to the results of the research studies conducted in the American companies (during the last 3 years results in the analysis of the 88 companies), working capital management directly influences the company’s profitability. The working capital management is concerned with the current assets only; it is related to the current and non-current liabilities. When liabilities go upward for increases as a result of this, profit goes down. Only a balance in the assets and liabilities can ensure profit for the company. The cash conversion cycle (CCC) is one of the famous measures of work capital management. The cash conversion cycle gets effects from the time duration. The long time duration cycle for the cash conversion in companies increases the profit of the company.

While on the other hand, a short cash conversion cycle results in a decrease in profitability. Accounts payable is also one of the components of working capital management. For the management of the working capital, companies adopt three types of strategies/approach conservative, aggressive, and hedging approach (Gill, Biger, & Mathur, 2010). The conservative and aggressive approach reduces the shareholder’s value.

Discussion and Analysis

               Working capital management has a vital role in the success of a company. Working capital is equally important in all kinds of business, no matter which industry and target market the company operates. Working capital presents the company’s amount for operations in its assets side (Nazir & Afza, 2009). To estimate the total working capital, we view the capital required to hold the current assets. Working capital and net-working capital are relatively different from each other. Net-working capital describes the difference between the total current assets side and current liabilities side. However, networking capital is the amount that is financed by the long term debt of the company.

In working capital management, companies decide about the total current assets of the company. After determining the limit for the current assets requirements, management decides about the financing policy (Nazir & Afza, 2009). Management decides about the total requirement of the financing, what sources will be used to finance, and whether the financing will be based on the short term liabilities or long term liabilities. In this paper working, capital management is discussed in detail. While in financing the current assets of the company, management has three primary options the aggressive approach, conservative approach, and hedging approach that is discussed below in brief details:

  1. Aggressive Approach:

The aggressive approach of financing is the riskiest approach for the companies, especially when companies are working in a highly competitive environment and have limited inventory sales chances on an immediate basis. In this approach, management decides to finance the current assets (cash and other cash equivalents) with short-term debt/ liabilities as loans and credit sales. Risk factors get enhance when management also finances the permanent working capital with the temporary working capital.

Working Capital Management

Figure 1 Aggressive Approach of Working capital management

In the diagram mentioned above, the impact of an aggressive approach for financing the working capital is presented. According to the figure, 1 company is financing permanent working capital with the long-term debt, while for the temporary working capital, they are using short term funds. Most of the time, management applies the approach to finance the assets most cost-effectively. In this approach, management mainly focuses on short-term debt rather than the long term. Thus, they pay less interest on liabilities or funds compared to long-term financing. However, at the same time, the aggressive approach requires high alerts all the time because companies have to pay back that short-term within the fiscal year. An aggressive approach to working capital management is efficient for the companies that have run the business and quick sales of inventory. Otherwise, the company will face difficulty in paying back the short-term loans.   

  1. Conservative Approach:

The Conservative approach of financing is quite the opposite of the aggressive approach of financing working capital. In this approach, management wants to have more current assets than short-term debt. According to this approach, management prefers to have more cash reserves in the business; therefore, they avoid short term funds and loans—companies following the conservative approach finance the company’s current assets with long-term debt.

  1. Hedging Approach:

In the matching approach or hedging approach, management maintains the optimal level in the business. According to this approach, companies set a limit for the permanent current assets and current temporary assets—long-term debt finance the company’s fixed and non-current assets. In comparison, current temporary assets get financing from the short term funds and loans. Following the optimal level management and hedging approach, managers try to maintain the accounts payables and account receivable and manage cash in the business.

   Solvency and liquidity are the most influencing factors in working capital management. Liquidity and solvency are directly concerned with the profitability of the company. In the above discussion and literature review, working capital is discussed in detail (Gill, Biger, & Mathur, 2010). According to the analysis of that information, it can be stated that the company’s success depends on working capital management. Financial managers in the companies can increase or limit the company’s profitability through the selection of approach and be taking their decisions towards working capital management approaches.

Researchers explain some components of working capital management as cash and cash equivalent, accounts receivable, accounts payable, and inventory. Through cash management, companies avoid the problem of insolvency in the business. Companies face challenges to run operations most appropriately whenever the business’s cash level decreases, and accounts receivables increase. Time value of money and risk of payback are the significant factors that influence the management to maintain the accounts receivable’s optimal level. Companies cannot wholly avoid and boycott credit sales (selling products or services on accounts receivable). Customers can switch to other brands in a highly competitive environment if they do not offer credit sales as customers want ease.      

It is effortless to determine whether the company is adopting the aggressive policy of investment and aggressive financial policy or not? The ratio analysis of the current assets and current liabilities unable the managers to understand the financing policies. For the determination of aggressive investment policy, the following formula can be used:

According to the formulas mentioned above, the lower ratio of the aggressive investment policy indicates adopting an aggressive investment policy. While on the other hand, if the ratio of total current assets divided by the total assets is 2 or greater than 2, the company is adopting an aggressive financing policy. According to the literature review and analysis of the research paper, it can be concluded that the cost of the capital decreases when a company adopts the aggressive working capital approach and increase when they adopt the conservative approach. Here a table is presented below that describe the effects of approaches on the business:

Aggressive Conservative Hedging
Risk factor High Low In between
Cost of capital Low High In between
Equity High Low In between

According to the table mentioned above, the conservative approach has a lower risk factor and a high capital cost that seems to attract the companies. While in reality, the conservative approach also has some limitations as it has the lowest return on equity because, in the conservative approach, companies use long-term debt to finance the current assets with the point of view that they will have to pay it later after one year. But with time, interest expense increases, and in the end, the company pays back more money to the creditors than the short-term loans because of interest expense. Thus, in such a situation, an aggressive or conservative approach, both cannot be considered the practical approach of management. Financial managers of the companies should select the approach for working capital management according to the company’s current situation.  

Conclusion

Working capital management has great importance in determining the profitability of the company. The whole discussion and literature review concluded that the best approach for working capital management is to adopt the hedging approach. In comparison, companies can run operations effectively and speedily than an aggressive approach can be useful. Success depends upon the company’s management rather than the approaches, as several companies are working in the current market as successful companies even when following the aggressive approach. Managers of such companies follow up aggressive approach management and efficiently manage working capital to increase profit through financial leverage.

References
  • Abor, J. Y. (2016). Working Capital Management. Entrepreneurial Finance for MSMEs, 225-255.
  • Afza, T., & Nazir, M. S. (2007). IS IT BETTER TO BE AGGRESSIVE OR CONSERVATIVE IN MANAGING WORKING CAPITAL? Journal of Quality and Technology Management, 3(2), 11-21. Retrieved 07 22, 2018
  • Baños-Caballero, S., García-Teruel, P., & Martínez-Solano, P. (2014). Working capital management, corporate performance, and financial constraints. Journal of Business Research, 332-338.
  • Gill, A., Biger, N., & Mathur, N. (2010). The Relationship Between Working Capital Management And Profitability: Evidence From The United States. Business and Economics Journal, 10(1), 1-9. Retrieved 07 22, 2018
  • Mathuva, D. M. (2010). The influence of working capital management components on corporate profitability. Research Journal of Business Management, 1-11.
  • Nazir, M. S., & Afza, T. (2009). Impact of Aggressive Working Capital Management Policy on Firms’ Profitability. IUP Journal of Applied Finance, 15(8), 19. Retrieved 07 22, 2018

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