Download - Chapter Working Capital Management
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Chapter 26
WORKING CAPITAL MANAGEMENT
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OUTLINE
Introduction
Constituents of current assets & current liabilities
Characteristics of Current Assets
Factors Influencing Working Capital Requirements
Level of Current Assets
Current Assets Financing Policy
Profit Criterion for Current Assets
Operating Cycle Analysis
Cash Requirement for Working Capital
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INTRODUCTION
This chapter introduces working capital management or short term
financial management which is concerned with decisions relating tocurrent assets & current liabilities
The key difference between LTFM & WCM is in terms of the timing
of cash
Two concepts of working capital:
a. Gross working capital: Total of all current assets
b. Net working capital: Current assets Current Liabilities
Importance of Working Capital:
a. Investment in current assets represents a substantial portion of total
investment
b. Investment in current assets & the level of current liabilities have to
be geared quickly to changes in sales
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CONSTITUENTS OF
CURRENT ASSETS & CURRENT LIABILITIES
Current Assets:
Inventories
- Raw material
- Work in Process- Finished Goods
- Others
Trade Debtors
Loans & Advances
Cash & Bank Balance
Current Liabilities:
Sundry Creditors
Trade Advances
Borrowings [Short Term]- Commercial Banks
- Others
Provisions
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CHARACTERISTICS OF CURRENT ASSETS
Short life span
Swift transformation into other asset forms
Current Assets Cycle
Accounts
receivable
Finished
goods
Wages, salaries,
factory overheads
Work-in-
process
Raw
materials
Cash Suppliers
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Implications of Current Assets:
1. Decisions relating to working capital management are repetitiveand frequent
2. The difference between profit and present value is insignificant
3. Efficient management of one component cannot be undertaken
without simultaneous consideration of other components
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FACTORS INFLUENCING
WORKING CAPITAL REQUIREMENTS
Nature of Business
-Service Firm: Modest WC requirement
-Manufacturing Firm: Substantial WC requirement Seasonality of Operations
Production Policy
Market Conditions
Conditions of Supply
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WORKING CAPITAL POLICY
Two important issues in working capital policy are:
What should be the level of investment in current
assets?
What mix of long-term and short-term financing should
the firm employ to support current assets?
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LEVEL OF CURRENT ASSETS
Flexible Restrictive
(Conservative) (Aggressive)Policy Policy
Liquidity High Low
Inventories Large Small
Debtors High Low
A flexible policy results in fewer production stoppages, ensures
quicker deliveries to customers, and stimulates sales .. but
HIGHER INVESTMENT IN CURRENT ASSETS
A restrictive policy leads to more production stoppages, delayed
deliveries to customers, and lost sales but
LOWER INVESTMENT IN CURRENT ASSETS
- Refer Exhibit 26.4 on Page 695
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CAPITAL REQUIREMENTS
AND THEIR FINANCING
Capital
requirements
Fluctuating currentasset requirement
Permanent current
asset-requirement
Fixed asset
requirement
Time
A
B
C
- Refer Page 696
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CURRENT ASSETS FINANCING
POLICY
According to the matching principle, fixed assets and
permanent current assets should be supported by long-
term sources of finance whereas fluctuating current assets
must be supported by short-term sources of finance.
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PROFIT CRITERION FOR
WORKING CAPITAL
Investment in current assets is easily reversible.
For reversible investments, the criterion of net profit per
period (which here means residual income) is equivalent
to the criterion of net present value
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OPERATING CYCLE AND CASH CYCLE
The investment in working capital is influenced by four key events in the
production and sales cycle of the firm:
-Purchase of raw materials
-Payment of raw materials
-Sale of finished goods-Collection of cash for sales
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OPERATING CYCLE AND CASH CYCLE
Order placed Stock arrives Goods sold Cash received
Inventory period Accounts
receivable period
Accounts
payable period
Firm receives Cash paid for
invoice materials
Operating cycle
Cash cycle
Average inventory
Inventory period =
Average COGS / 365
Average accounts receivable
Accounts receivable period =
Annual sales / 365
Average accounts payable
Average payable period =
Average COGS / 365
-The operating cycle= Inventory period + Accounts receivable period-The cash cycle= Operating cycle - Accounts payable period
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ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data
Profit and Loss Beginning of End of
Account Data 20X0 20X0
Sales 800 Inventory 96 102
Cost of goods 720 Accounts receivable 86 90
Sold Accounts payable 56 60
(96 + 102) / 2Inventory period = = 50.1 days
720 / 365
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(86 + 90) / 2
Accounts receivable period = = 40.2 days
800 / 365
(56 + 60) / 2
Accounts payable period = = 29.4 days
720 / 365
Operating cycle = 50.1 + 40.2 = 90.3 daysInventory Accounts
period receivable
period
Cash cycle = 90.3 - 29.4 = 60.9 days
Operating Accounts
cycle payable period
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CASH REQUIREMENT FOR
WORKING CAPITAL
Step 1 : Estimate the cash cost of various current assets
required by the firm.
Step 2 : Deduct the spontaneous current liabilities from
the cash cost of current assets
- Refer Page 701
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SUMMING UP
Current assets have a short life span and are swiftly
transformed into other asset forms.
The working capital needs of a firm are influenced by
numerous factors : nature of business, seasonality of
operations, production policy, market conditions, andsupply conditions.
Determining the optimal level of current assets involves
a tradeoff between carrying costs and shortage costs.
According to the matching principle, the maturity of the
sources of finance should match the maturity of assets
being financed.
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The operating cycle of a firm begins with the acquisition
of raw materials and ends with the collection of
receivables.
The cash requirement of working capital is calculated by
estimating the cash cost of various current assets
required by the firm and deducting the spontaneous
current liabilities from the cash cost of current assets.
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PRACTICE TIME!!!
- Refer to the SOLVED PROBLEMS given at the end of the chapter- Solve all UNSOLVED PROBLEMS