Working Capital refers to the cash which is required by a business entity to run its day to day operations. It is a measure of the efficiency with which a company conducts its operations and the financial conditions of a company in short run (Bhattacharya 2009). The working capital is equated against the short term components of the balance sheet as follows:
- Working Capital = Current Assets – Current Liabilities
If a company has a positive working capital, i.e. the value of current assets of the company is greater than the total current liabilities’ value; then it suggests that the company can meet its short term liabilities. On the other hand, if the working capital turns out to be negative, i.e. the total current assets are less than total current liabilities; then it means that the company cannot pay off its short term liabilities. This situation is not favorable for a company as the company may run into bankruptcy due to non payment to its creditors (Bhattacharya 2009, Hill 2008).
Significance of Working Capital for a Company
The working capital ratio keeps on changing for a company and can be adjusted quickly by introducing different variations to the proportion of current assets and current liabilities held by the company. However, if the working capital ratio shows a declining trend in the long run; it may be a sign of trouble for the company. This may happen, as for instance, when the revenue generated from sale of goods starts declining and the amount to be received from the debtors of the company does not grow thus decreasing the amount of total current assets (Priester and Wang 2010).
Apart from other financial ratios, investors consider the working capital ratio of a company to get an idea as to the operational efficiency of a company. Working capital is also affected by other ratios maintained by the company. As for instance, the amount of cash which the company ties up in inventory stocks and accounts receivable cannot be instantly used by that company for paying off an obligation. Therefore, if the turnover for account receivable is slow, it will although increase the current assets of the company but the liquidity level will be low and hence indicates inefficient operations of the company (Shin and Soenen 1998, García-Teruel and Martínez-Solano 2007).
For these reasons, a company needs to manage and maintain its working capital to optimum levels by achieving suitable levels for current assets and current liabilities and ensuring that the company is efficient enough in collecting its amounts receivable from the debtors. Apart from benefits relating to potential investors, efficient management of working capital also allows a company to improve its earnings significantly (Deloof 2003, Scherr 1989).
Working Capital Management Techniques
There are various methods by which companies can manage their working capital. The choice of a particular technique for managing working capital is determined by the nature of business of the entity and the needs relating to working capital. The three most followed working capital management approaches include reducing or managing inventory levels, speeding up the collection time of receivables and reviewing the credit terms with the creditors of the business (Peel and Wilson 1996, Moore and Reichert 2006). A company needs to manage working capital by way of focusing on all the three areas mentioned above, however, based on the needs and requirements of the business, a company may opt to follow a particular course of action, i.e. the company may decide to put more emphasis on one of the identified management techniques. Apart from the internal needs and requirements of a company, the working capital management technique is also determined by the industry wide conditions and trends, competitive environment and the regulatory environment under which the company operates (Buchmann and Jung 2010, Lamberson 2004, Mathur 2002). The three identified working capital management techniques are discussed below.
- Reducing or managing inventory levels
Managing or reducing inventory levels allows a company to create a source of cash. Most of the savings related to cash can be made by managing inventories effectively. Management of inventory can be attained by bringing in efficiency in the organizational / manufacturing processes, budgeting and forecasting and addressing the imbalance among the processes related to creditors and debtors (Buchmann and Jung 2010, H. Bhattacharya 2004). The levels of inventory can be managed or reduced by a company through following techniques:
- Efficient Forecasting and Demand Planning:
By way of improving the budgeting and forecasting and getting up to date with the demand of the product dealt with, a company can reduce its inventory levels and thus becomes able to hold sufficient amount of cash reserves (Buchmann and Jung 2010, Preve and Sarria-Allende 2010).
- Efficient Supply and Delivery Mechanisms:
Nowadays business entities have developed advanced supply management systems which allow them to interact with their suppliers in accordance with the demand conditions existing in the market. This includes the application of models like Economic Order Quantity (EOQ), Just In Time (JIT), etc. (Buchmann and Jung 2010, Jain 2004).
- Efficient Manufacturing Procedures:
Optimized or efficient manufacturing processes allow companies to reduce inventory withheld in work in process. This can be achieved by companies by reducing the inventories stuck in work in process while considering the demand of the product being manufactured. In this way optimum levels of inventory are held by the company and cash reserves are increased (Buchmann and Jung 2010, Kumar 2001).
- Prioritizing of Inventory Items:
A company can manage its inventory levels by focusing on maintaining high levels of inventory stocks for those items which have a higher demand, while reducing the levels for those stock items which are slow moving and have a lower demand (Buchmann and Jung 2010).
Disadvantage of Inventory Levels Management
The management of inventory, which usually involves the reduction of inventory stocks which are maintained by a company, results in a disadvantage for the entity doing so. The disadvantage is that after reducing the size of inventory held by the company, there is a possibility that the company may not be able to cope up to demand of the customers and therefore decrease in revenues may result (McInnes 2010).
Those companies which intend to employ this management technique to improve the working capital ratio, shall analyze carefully the demand conditions in the market of their products and the ability to meet those demands with reduced inventory levels. After doing so, the companies shall decide as to whether the planned management plan will work for them or not (Jain 2004).
Speeding up the collection time of receivables
One major factor which deteriorates the networking capital structure of an organization is lack of coordination between receipt and payment of cash. In short, some companies collect the amount receivable from their customers late but pay their creditors early. This situation calls for an efficient system of managing the receipt of cash to be received from the debtors of a company (Buchmann and Jung 2010, Gentry and De La Gazra 1985). This efficiency can be attained through following techniques:
- Invoicing Cycle:
The main objective in this approach is to dispatch invoices to the debtors in a swift way. This technique, however, requires other business process to be active and efficient also. As for instance, the billing department of a company can only generate invoices to the customers promptly if there are no pending matters relating to other departments. Any disruption or discontinuity in a process will slow down the invoicing process (Buchmann and Jung 2010).
- Early Reminders to Debtors:
It is a general observation that customers tend to delay payments, which significantly affect the liquidity position of the receiving company. Early reminders help in reducing late payments by customers and thus increase cash inflows (Buchmann and Jung 2010).
- Payment Terms:
Favorable payment terms help in reducing Days Sale Outstanding (DSO). While negotiating the payment terms with the customers, the companies shall keep in mind the bargaining power of the customers to determine payment terms which are acceptable for both parties (Buchmann and Jung 2010).
Disadvantage of Collection time Reduction
When a company aims at collecting the amounts receivable from its customers before due dates, it has to offer some consideration in return to those customers who are willing to pay early. In this regard, the usual practice is the offering of discount or waiver of certain percent of the amount receivable. This discount reduces the amount received by the company due to reducing the collection time. Therefore, reducing collection time has a disadvantage of bringing down the receivable amounts (Jain 2004).
To account for this situation, companies which are intending to use this working capital management approach and at the same time do not want to experience a decrease in their earnings, shall focus on reducing the delay in collection of amounts to be received instead of offering discount for payments received before due dates (Jain 2004).
Reviewing the credit terms with the creditors of the company
As a company shall manage its cash collection time, likewise, it is also required that the company shall manage its payments to the creditors. This can be done in the following manners:
- Payment Cycle:
Although payment cycle of an entity is determined by the industry in which an entity operates and the terms and conditions attached to the agreements between the two parties, but the entity shall strive towards following a payment cycle which does not drain the cash in frequent intervals and at the same time is not unfavorable for the suppliers also (Buchmann and Jung 2010).
- Avoiding Early Payments:
To ensure the sufficiency of cash reserves, a company shall avoid very early payments and try to negotiate payment terms with its suppliers which are favorable for the management of its net working capital (Buchmann and Jung 2010).
- Payment Conditions:
Such payment conditions shall be set which allow the company to manage its working capital efficiently. To do this, the company shall negotiate the payment conditions with its suppliers from time to time to gain advantage related to extension of payment time period (Buchmann and Jung 2010).
Disadvantage of Increasing the Payment Time
Where a company decides or makes arrangement with its suppliers that the payment of the amount due will be delayed by the company, the company may go away with losing the benefit of available discounts which are available on timely payment or payments made before due date (Jain 2004).
Analysis and Discussion of the Working Capital – The Coca Cola Company and PepsiCo Inc
To present an analysis of the working capital, two real life scenarios have been considered here, i.e. The Coca Cola Company Inc. and PepsiCo Inc. Below is the table presented which includes the current assets and liabilities for the last two financial years, 2009 and 2010, for The Coca Cola Company Inc.
Table – 01: Current Assets and Liabilities of Coca Cola Company in 2009 and 2010
|COCA COLA COMPANY – Excerpt from Balance Sheet for the year ended Dec 31, 2010|
|Cash and Cash Equivalents||$ 8,517||$ 7,021|
|Short term Investments||$ 2,682||$ 2,130|
|Marketable Securities||$ 138||$ 62|
|Trade Accounts Receivable (less allowance of $ 48 and $ 55)||$ 4,430||$ 3,758|
|Inventories||$ 2,650||$ 2,354|
|Prepaid Expenses and Other Assets||$ 3,162||$ 2,226|
|Total||$ 21,579||$ 17,551|
|Accounts Payable and Accrued Expenses||$ 8,859||$ 6,657|
|Loans and Notes Payable||$ 8,100||$ 6,749|
|Current Maturities of Long Term Debt||$ 1,276||$ 51|
|Accrued Income Taxes||$273||$ 264|
|Total||$ 18,508||$ 13,721|
The information presented in the table can be used to calculate the working capital of The Coca Cola Company for two years as follows:
Working Capital (2009) = $ 17,551 million – $ 13,721 million
= $ 3,830 million
Working Capital (2010) = $ 21,579 million – $ 18,508 million
= $ 3,071 million
It can be observed that the net working capital in the year 2010 has decreased by $ 759 million. The major reason behind this decrease is that the accounts payable and short term loans have increased significantly in 2010. On the other hand, the current assets have although increased but not in the same proportion as in the case of current liabilities. Therefore, the company is experiencing a negative working capital trend from 2009 to 2010.
On the other hand, following table presents the figures related to current assets and liabilities of PepsiCo Inc. for the year 2009 and 2010.
Table – 02: Current Assets and Liabilities of PepsiCo Inc. in 2009 and 2010
|PEPSICO – Excerpt from Balance Sheet for the year ended Dec 31, 2010|
|Cash and Cash Equivalents||$ 5,943||$ 3,943|
|Short term Investments||$ 426||$ 192|
|Accounts and Notes Receivable, net||$ 6,323||$ 4,624|
|Inventories||$ 3,372||$ 2,618|
|Prepaid Expenses and Other Assets||$ 1,505||$ 1,194|
|Total||$ 17,569||$ 12,571|
|Accounts Payable and Accrued Expenses||$ 10,923||$ 8,127|
|Short Term Obligations||$ 4,898||$ 464|
|Accrued Income Taxes||$ 71||$ 165|
|Total||$ 15,892||$ 8,756|
The information presented in the table can be used to calculate the working capital of the PepsiCo Inc. for two years in the following manner:
Working Capital (2009) = $ 12,571 million – $ 8,756 million
= $ 3,815 million
Working Capital (2010) = $ 17,569 million – $ 15,892 million
= $ 1,677 million
Similar to the case of The Coca Cola Company Inc., the networking capital of PepsiCo Inc. has also declined from the financial year 2009 to 2010 by a huge amount of $ 2,138 million. Considering the data presented in Table – 02, there is an increase in the cash and cash equivalent component of current assets in 2010 by an amount of $ 2,000 million. Similarly, accounts and notes receivable have also increased in 2010 by $ 1,700 million approximately. However, these increases are not enough to cover the increases in different components of current liabilities. As for instance, there is a significant increase in the accounts payable and accrued expenses in 2010, i.e. $ 2,796 million. Therefore, the networking capital for PepsiCo Inc. is also moving in a negative direction.
Working Capital is a key factor in determining the liquidity of a company and it is due to this reason investors and shareholders show interest in getting to know the net working capital of a company. Working capital management is considered as one of the major areas by the management of a company as it enables a company to plan and make budgets for future periods. The primary motive behind managing working capital is to ensure that the liquidity position of a company is up to the mark. There are various ways in which a company may manage its working capital, which include managing the inventory levels, reducing the account receivable collection time period and reviewing credit terms with the creditors of the company. Along with the benefits of these techniques of managing working capital, there are certain limitations also which can be dealt with proper planning.
List of References
Bhattacharya, H., 2004. Working Capital Management: Strategies and Techniques. New Delhi: PHI Learning Pvt. Ltd.
Bhattacharya, H., 2009. Working Capital Management – Strategies and Techniques. 2nd ed. New Delhi: PHI Learning Pvt. Ltd.
Buchmann, P. and Jung, U., 2010. Best-Practice Working Capital Management: Techniques for Optimizing Inventories, Receivables, and Payables. Web.
Deloof, M., 2003. Does Working Capital Management Affect Profitability of Belgian Firms? Journal of Business Finance and Accounting, 30(3-4), pp.573-88.
García-Teruel, P.J. and Martínez-Solano, P., 2007. Effects of working capital management on SME profitability. International Journal of Managerial Finance, 3(2), pp.164-77.
Gentry, J.A. and De La Gazra, J.M., 1985. A Generalized Model for Monitoring Accounts Receivable. Financial Management, 14(4), p.28.
Hill, R.A., 2008. Strategic Financial Management. Finance and Ventus Publishing.
Jain, N.K., 2004. Working capital management. New Delhi: APH Publishing.
Kumar, A.V., 2001. Working Capital Management. New Delhi: Northern Book Centre.
Lamberson, M., 2004. Financial Analysis and Working Capital Management Techniques used by Small Manufacturers: Survey and Analysis. Web.
Mathur, S.B., 2002. Working Capital Management and Control: Principles and Practice. New Delhi: New Age International Pvt. Ltd. Publishers.
McInnes, A., 2010. Working Capital Management. Lambert Academic Publishing.
Moore, J.S. and Reichert, A.K., 2006. AN ANALYSIS OF THE FINANCIAL MANAGEMENT TECHNIQUES CURRENTLY EMPLOYED BY LARGE U.S. CORPORATIONS. Journal of Business Finance and Accounting, 10(4), pp.623-45.
Peel, M.J. and Wilson, N., 1996. Working Capital and Financial Management Practices in the Small Firm Sector. International Small Business Journal, 14(2), pp.52-68.
PepsiCo. Annual Report 2010. Annual Report. New York: PepsiCo Inc.
Preve, L.A. and Sarria-Allende, V., 2010. Working capital management. Oxford University Press.
Priester, C. and Wang, J., 2010. Financial Strategies for the Managers. Tsinghua University Texts.
Scherr, F.C., 1989. Modern working capital management: Text and cases. Englewood Cliffs: Prentice Hall.
Shin, H.H. and Soenen, L., 1998. Efficiency of Working Capital Management and Corporate Profitability. Financial Management, pp.37-45.
The Coca Cola Company, 2010. Annual Report 2010. Annual Report. Atlanta: The Coca Cola Company Inc.