Approaches to Managing Working Capital

Generally two approaches are followed for the management of working capital :

(i) the conventional approach and (ii) operating cycle approach.

The Conventional Approach: In this approach, each individual component of working capital viz. cash, inventory, receivables, payables etc. are managed efficiently such that, neither there is shortage of funds nor there is accumulation of excess funds. Since the cash position of the forms is affected by the management of the other items of working capital, the basic strategies that can be employed for the management of cash are 

(i) efficient inventory management

(ii) speedy collection of accounts receivables and 

(iii) stretching accounts payment without affecting the credit of the firm. 

An efficient inventory management is one that provides maximum customers service at a minimum cost. The optimum level of inventory is decided on the basis of the trade-off between cost of keeping inventory and benefits from it. As you know that inventory of a firm comprises of various items like, different types of raw materials, semi-finished goods in various stages of production, finished goods etc., it is not necessary for the manager to exercise same degree of control on all the items of inventory. The items which are most costly and/or converted into cash relatively slowly require more control. Hence, in the inventory control process, the inventory items are classified into three categories on the basis of the cost involved according to A B C System of classification. The items included in group A involve the largest investment and C group consists of cheapest items. Therefore,most rigorous and intensive control is required for A group of inventories and C deserve minimum attention. B group stands mid-way. It deserves less attention according to A B C System of classification. The items included in group A involve the largest investment and C group consists of cheapest items. Therefore,most rigorous and intensive control is required for A group of inventories and C deserve minimum attention. B group stands mid-way. It deserves less attention than A but more than C.

For receivable management, the firm has to decide whether or not to extend credit to a customer, how much credit to extend, what should be period for which credit is given, procedure for collection, in case of default etc. Similarly, the extent to which you can stretch your accounts payable will depend upon the credit policy, credit terms and collection policy of the creditor. There is no fixed norm for each of the above questions. The decision of the firm will be guided by the general nature of business, business environment and risk taking ability of the entrepreneur.

The Operating Cycle Approach: Under this approach, the working capital is determined by the duration of the operating cycle and the operating expenses needed for completing the cycle. In other words, this approach views working capital is a function of the volume of operating expenses.

The operating cycle has five major stages, (I) expenditure for purchasing raw material, stores etc. (II) inputs inventory (III) process interval (IV) warehouse(storage) interval and (V) collection interval. The operating cycle maintains circular flow of working capital from stage one through stage five as shown in the figure below. An effective management of working capital is that in none of these stages there is shortage of working capital nor there is excess of it.