Working Capital: Management, Policies & Real-World Trade-offs

What is Working Capital?

Working capital (WC) is the difference between a company’s current assets and current liabilities: $$\text{Working Capital}=\text{Current Assets}-\text{Current Liabilities}$$ It measures a firm’s short-term financial health—its ability to pay bills today while funding daily operations. Positive WC means more liquidity; negative WC (overtrading) signals distress.

Why Does It Matter?

• Liquidity: Can the company pay suppliers, salaries, and taxes now?
• Profitability: Excess cash earns low returns; too little cash risks bankruptcy.
• Growth: Firms need WC to seize opportunities (e.g., bulk discounts, new markets).

Working Capital Components

1. Current Assets (Cash + Near-Cash)

2. Current Liabilities (Short-Term Debts)

Working Capital Management: The Core Goals

Firms must balance three conflicting priorities:

1. Liquidity: Avoid running out of cash (e.g., Ncell’s daily collections).
2. Profitability: Minimize idle cash (e.g., banks lending excess reserves).
3. Risk: Too much debt = insolvency; too little = missed growth.

The Trade-Off Visualized

Example: A Kathmandu garment shop holds 3 months’ inventory (liquidity) but loses 10% profit margin on unsold stock (profitability vs. risk).

Working Capital Policies: Aggressive vs. Conservative

Firms choose policies based on their industry and risk tolerance. Here’s how they differ:

In the Real World

1. eSewa’s Float Management

   • Idea: Cash vs. Accounts Receivable
   • eSewa holds only 2–3 days’ cash float (aggressive policy) to lend excess to merchants via eSewa Business. If cash drops below 1 day, it borrows from banks (short-term loan). This maximizes profitability but risks liquidity crises during peak transaction days (e.g., Dashain).

2. Daraz’s Inventory Turnover

   • Idea: Inventory Management
   • Daraz’s Kathmandu warehouse turns stock every 45 days (high turnover = low holding costs). It uses just-in-time (JIT) ordering from suppliers like Decathlon to avoid dead stock (e.g., unsold winter gear in summer).

3. NTC’s Accounts Payable Strategy

   • Idea: Trade Credit Optimization
   • NTC delays payments to suppliers (e.g., Huawei for network equipment) by 60–90 days (stretching AP). This frees up cash for capex (e.g., 4G expansion) but risks supplier penalties or strained relationships.

Working Capital Cycle: How Cash Flows

Every transaction affects WC. Trace the cycle for Kathmandu Retail Shop (KRS), a small business:

flowchart TD
    A["1. Buy Inventory\n(AP ↑, Cash ↓)"] --> B["2. Sell on Credit\n(AR ↑, Inventory ↓)"]
    B --> C["3. Collect AR\n(Cash ↑, AR ↓)"]
    C --> D["4. Pay AP\n(Cash ↓, AP ↓)"]
    D --> A

Worked Example: KRS’s Monthly WC

• Start: Cash = ₹50,000; Inventory = ₹100,000; AP = ₹80,000.
• Step 1: Buys ₹60,000 more inventory on credit.
  • New WC = (₹50k + ₹100k + ₹60k) – (₹80k + ₹60k) = ₹70,000.
• Step 2: Sells ₹80,000 of inventory on credit.
  • New WC = (₹50k + ₹80k + ₹20k) – (₹80k + ₹60k) = ₹10,000 (liquidity risk!).
• Step 3: Collects ₹50,000 from customers.
  • New WC = (₹100k + ₹20k) – (₹80k + ₹60k) = ₹-10,000 (negative WC = emergency!).

Solution: KRS must:

1. Negotiate longer payment terms with suppliers (reduce AP).
2. Offer discounts for cash sales (reduce AR).
3. Take a short-term loan to cover the gap.

Key Ratios to Measure WC Efficiency

Tools to Manage WC

1. Inventory Management

• Just-in-Time (JIT): Order stock only when needed (used by Daraz).
• ABC Analysis: Prioritize high-value items (e.g., electronics vs. stationery).
• Safety Stock: Buffer for demand shocks (e.g., Kathmandu shops stock extra before Dashain).

2. Accounts Receivable Management

• Credit Policy: Set terms (e.g., "Net 30") and enforce penalties for late payments.
• Factoring: Sell AR to a bank (e.g., Global IME Bank buys Daraz’s receivables).
• Discounts: Offer 2% off for cash payments (reduces AR days).

Example: If KRS offers a 1% discount for cash, it might collect 60% of sales upfront, improving WC by ₹48,000/month (assuming ₹80,000 sales).

3. Accounts Payable Management

• Stretch Payments: Delay payments as long as possible without penalties.
• Supplier Negotiation: Trade discounts for early payments (e.g., "2/10, Net 30").
• Consolidation: Combine small payments into fewer, larger ones.

Example: NTC pays a supplier ₹50M but negotiates Net 60 instead of Net 30, freeing ₹50M for 30 days.

4. Cash Management

• Lockbox System: Customers send payments to a PO box near the bank (faster collections).
• Zero-Balance Accounts: Only keep enough cash for daily needs (e.g., Pathao’s driver payouts).
• Short-Term Investments: Park excess cash in T-bills (e.g., NMB Bank’s 90-day placements).

Financing Working Capital

Firms fund WC through:

1. Spontaneous Sources: AP, accruals (free but risky).
2. Short-Term Loans: Bank overdrafts, commercial paper (e.g., Ncell’s ₹2B loan).
3. Long-Term Debt: Issue bonds or take term loans (e.g., NMB’s 5-year working capital facility).
4. Equity: Issue new shares (dilutes ownership; rare for WC).

Comparison Table:

Seasonal Working Capital Needs

Many Nepali businesses face seasonal demand swings:

• Retail: High WC before Dashain/Tihar (inventory) but low in summer.
• Tourism: Hotels need peak-season cash (June–August) but have surplus in monsoon.
• Agriculture: Farmers need loans before planting (Chaitra–Baisakh) but repay after harvest.

Solution: Seasonal Financing

• Borrow short-term during peak (e.g., ₹50M loan for 6 months at 12%).
• Repay from cash flows during off-peak.

Example: A Kathmandu hotel borrows ₹20M in April for summer staff and repairs. It repays from ₹50M in June–August revenues.

Exam Tip

What Examiners Want to See

1. Definitions: Know the exact terms (e.g., "Working capital is not the same as net working capital").
2. Calculations: Practice ratio computations (e.g., "If AR turnover is 8x and sales are ₹100M, what’s AR?").
3. Policy Trade-offs: Compare aggressive vs. conservative policies with real Nepali examples.
4. Cycle Analysis: Draw the WC cycle and explain where cash is tied up (e.g., "Inventory days = 60 means ₹X is stuck in stock").
5. Ratio Interpretation: Flag "red flags" (e.g., "Current ratio <1 means liquidity crisis").

Common Pitfalls

• Ignoring Industry Norms: A retail shop’s WC needs differ from a bank’s.
• Miscounting Days: AR turnover of 12x = 30-day AR (not 12 days).
• Overlooking Seasonality: Assume demand is constant unless stated otherwise.

Model Answer Structure

For a 5-mark question on WC management:

1. Define WC (1 mark).
2. List 2 current assets/liabilities (1 mark).
3. Explain one policy (e.g., "Aggressive WC uses more debt to fund growth") + Nepali example (2 marks).
4. Calculate one ratio (e.g., "If cash = ₹20M, AR = ₹30M, AP = ₹40M, current ratio = 1.0") (1 mark).

Practice Problem

Scenario: Kathmandu Electronics has:

• Cash: ₹5M
• AR: ₹15M
• Inventory: ₹20M
• AP: ₹25M
• Short-term loan: ₹10M

Questions:

1. Calculate its working capital and current ratio.
2. If it sells ₹8M of inventory on credit and collects ₹5M from AR, what’s the new WC?
3. Suggest two actions to improve its quick ratio (ignore inventory).

Solutions: 1.

• WC = (₹5M + ₹15M + ₹20M) – (₹25M + ₹10M) = ₹5M.
• Current Ratio = (₹40M) / (₹35M) = 1.14 (marginal).

2. • New Cash = ₹5M + ₹5M = ₹10M.
   • New AR = ₹15M – ₹5M + ₹8M = ₹18M.
   • New Inventory = ₹20M – ₹8M = ₹12M.
   • New WC = (₹10M + ₹18M + ₹12M) – (₹25M + ₹10M) = ₹5M (no change!).
3. • Action 1: Offer cash discounts to reduce AR (e.g., collect ₹5M upfront).
   • Action 2: Negotiate longer AP terms (e.g., delay ₹5M payment by 30 days).

Key Takeaways

• Working capital is the lifeblood of short-term operations—manage it poorly, and the business bleeds cash.
• Aggressive policies = higher risk/reward; conservative = safety but lower returns.
• Ratios (current, quick, turnover) reveal inefficiencies—compare to industry peers.
• Seasonality matters: Plan financing around cash flow peaks and troughs.
• Real-world tie: Every Nepali business—from Pathao’s driver payouts to NTC’s supplier payments—uses WC tools daily.