working capital mngt final

8/4/2019 Working Capital Mngt Final

1/52

INTRODUCTION

WORKING CAPITAL MANAGEMENT

Working capital management is concerned with the problems arise in attempting to

manage the current assets, the current liabilities and the interrelationship that existbetween them. The term current assets refers to those assets which in ordinary course ofbusiness can be, or, will be, turned in to cash within one year without undergoing adiminution in value and without disrupting the operation of the firm. The major currentassets are cash, marketable securities, account receivable and inventory. Currentliabilities ware those liabilities which intended at there inception to be paid in ordinarycourse of business, within a year, out of the current assets or earnings of the concern. The basic current liabilities are account payable, bill payable, bank over-draft, andoutstanding expenses. The goal of working capital management is to manage the firmscurrent assets and current liabilities in such way that the satisfactory level of workingcapital is mentioned. The current should be large enough to cover its current liabilities in

order to ensure a reasonable margin of the safety.

DEFINITION:-

1. According to Guttmann & Dougall-

Excess of current assets over current liabilities.

1. According to Park & Gladson-

The excess of current assets of a business (i.e. cash, accounts receivables, inventories)

over current items owned to employees and others (such as salaries & wages payable,accounts payable, taxes owned to government).

WORKING CAPITAL MANAGEMENT

Working capital refers to the firms investment in short-term assets (cash,marketable securities, accounts receivable and inventories). Net working capital is thedifference between a firms current assets and its current liabilities. Working capitalmanagement involves administering to both short-term assets and short-term liabilities.Assets and liabilities must be matched and coordinated in order to keep costs to aminimum and to control risks. Generally, we want to match the firms financing with the

lives of its assets. If we consider a company that is growing over time, then its assets can be decomposed into three categories fixed assets, permanent current assets andfluctuating current assets.


2/52

Short-termFluctuating

Current Assets

PermanentCurrent Assets Long-term

Fixed Assets

Fixed assets should be financed long-term, either equity or long-term debt, sincethe assets are long-lived and need financing for a long period of time. The current assetscan be broken down into two portions, permanentcurrent assets and fluctuatingcurrentassets. The permanent current assets represent base levels of inventories, receivables,etc., that will always be on hand. The fluctuating current assets represent the seasonal build-ups that occur, such as inventories before Christmas and receivables afterChristmas. The fluctuating current asset levels should be financed short-term since wedont want to pay financing charges all year if we only need the money for a four-monthperiod.

While the permanent current assets are, individually, short-lived assets, as acategory they are always there (hence, permanent) and will always need to be financed.Thus, the permanent current assets should also be financed long-term, just like the fixedassets. While it is possible to finance some of our permanent needs using short-termdebt, it is risky to do so. (Such financing is described as an aggressive working capitalfinancing policy in your text aggressive being associated with risky.) The risk offinancing permanent needs with short-term financing is twofold: first, short-term interestrates fluctuate much more than long-term interest rates. Rolling over short-term debtyear after year will subject you to greater fluctuation in your financing costs as a result.Probably a bigger risk is the inability to roll over the short-term debt every year. Youmay have a bad year and find that lenders are unwilling to refund the debt (forcing you todefault).

Of course, some companies take the opposite approach they will finance someof their seasonal needs of the fluctuating current assets with long-term financing. This isa conservative approach, but the financing is there when it is needed but it costs moneyduring those times when it is not needed.

Banks generally do not want companies to utilize them as a source of permanentfinancing. For this reason, many banks will require that a companys line of credit be


3/52

completely paid off for at least one month each year. This is to prevent the companyfrom using the bank for permanent financing. Of course, banks are essentially matchingtheir assets and liabilities as well. The difference is that a banks assets are its loans whichit matches to its sources of financing while firms match their financing to their assets.Since a banks financing source is predominantly short-term deposits, it wants its loan

portfolio to be predominantly short-term as well.

Life insurance companies and pension funds, on the other hand, have liabilitiesthat are many years in the future. They would prefer to make longer term loans so thatthere isnt the need to reinvest the money every year.

Working Capital Management

Every business needs investment to procure fixed assets, which remain in use for a longerperiod. Money invested in these assets is called Long term Funds or Fixed Capital.Business also needs funds for short-term purposes to finance current operations.

Investment in short term assets like cash, inventories, debtors etc. is called Short-termFunds or Working Capital. The Working Capital can be categorized, as funds neededfor carrying out day-to-day operations of the business smoothly. The management of theworking capital is equally important as the management of long-term financialinvestment. Every running business needs working capital. Even a business which is fullyequipped with all types of fixed assets required is bound to collapse without (i) adequatesupply of raw materials for processing; (ii) cash to pay for wages, power and other costs;(iii) creating a stock of finished goods to feed the market demand regularly; and, (iv) theability to grant credit to its customers. All these require working capital. Working capitalis thus like the lifeblood of a business. The business will not be able to carry on day-to-day activities without the availability of adequate working capital. The diagram shown on

the next page clarifies it: Working capital cycle involves conversions and rotation ofvarious constituents/components of the working capital. Initially cash is converted intoraw materials. Subsequently, with the usage of fixed assets resulting in value additions,the raw materials get converted into work in process and then into finished goods. Whensold on credit, the finished goods assume the form of debtors who give the business cashon due date. Thus cash assumes its original form again at the end of one such workingcapital cycle but in the course it passes through various other forms of current assets too.This is how various components of current assets keep on changing their forms due tovalue addition. As a result,


4/52

they rotate and business operations continue. Thus, the working capital cycle involvesrotation of various constituents of the working capital. While managing the workingcapital, two characteristics of current assets should be kept in mind viz. (i) short life span,and (ii) swift transformation into other form of current asset. Each constituent of currentasset has comparatively very short life span. Investment remains in a particular form ofcurrent asset for a short period. The life span of current assets depends upon the timerequired in the activities of procurement; production, sales and collection and degree ofsynchronization among them. A very short life span of current assets results into swift

transformation into other form of current assets for a running business. Thesecharacteristics have certain implications:

i. Decision regarding management of the working capital has to betaken frequently andon a repeat basis.ii. The various components of the working capital are closely related and mismanagementof any one component adversely affects the other components too.iii. The difference between the present value and the book value of profit is notsignificant. The working capital has the following components, which are in severalforms of current assets:

Stock of Cash Stock of Raw Material

Stock of Finished Goods

Value of Debtors

Miscellaneous current assets like short term investment loans &advances


5/52

Working capital

Working capital (abbreviated WC) is a financial metric which represents operatingliquidity available to a business, organization, or other entity, including governmentalentity. Along with fixed assets such as plant and equipment, working capital isconsidered a part of operating capital. Net working capital is calculated as current assets

minuscurrent liabilities. It is a derivation of working capital, that is commonly used invaluation techniques such as DCFs (Discounted cash flows). If current assets are less thancurrent liabilities, an entity has a working capital deficiency, also called a workingcapital deficit.

Working Capital = Current Assets Current LiabilitiesNet Operating Working Capital = Current Assets Non Interest-bearing CurrentLiabilitiesEquity Working Capital = Current Assets Current Liabilities Long-term Debt

A company can be endowed with assetsandprofitabilitybut short ofliquidity if its assetscannot readily be converted into cash. Positive working capital is required to ensure that afirm is able to continue its operations and that it has sufficient funds to satisfy bothmaturing short-term debt and upcoming operational expenses. The management ofworking capital involves managing inventories, accounts receivable and payable, andcash.

WORKING CAPITAL NEEDS

Different industries have different optimum working capital profiles, reflecting theirmethods of doing business and what they are selling.

Businesses with a lot of cash sales and few credit sales should have minimal tradedebtors. Supermarkets are good examples of such businesses;

Businesses that exist to trade in completed products will only have finished goods instock. Compare this with manufacturers who will also have to maintain stocks of rawmaterials and work-in-progress.

Some finished goods, notably foodstuffs, have to be sold within a limited periodbecause of their perishable nature.

Larger companies may be able to use their bargaining strength as customers to obtainmore favorable, extended credit terms from suppliers. By contrast, smaller companies,

particularly those that have recently started trading (and do not have a track record ofcredit worthiness) may be required to pay their suppliers immediately.

Some businesses will receive their monies at certain times of the year, although theymay incur expenses throughout the year at a fairly consistent level. This is often knownas seasonality of cash flow. For example, travel agents have peak sales in the weeksimmediately following Christmas.

Working capital needs also fluctuate during the year
http://en.wikipedia.org/wiki/Accounting_liquidityhttp://en.wikipedia.org/wiki/Accounting_liquidityhttp://en.wikipedia.org/wiki/Current_assetshttp://en.wikipedia.org/wiki/Current_liabilitieshttp://en.wikipedia.org/wiki/Current_liabilitieshttp://en.wikipedia.org/wiki/Current_liabilitieshttp://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Profit_(accounting)http://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/Accounting_liquidityhttp://en.wikipedia.org/wiki/Accounting_liquidityhttp://en.wikipedia.org/wiki/Current_assetshttp://en.wikipedia.org/wiki/Current_liabilitieshttp://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Profit_(accounting)http://en.wikipedia.org/wiki/Liquidity


6/52

The amount of funds tied up in working capital would not typically be a constant figurethroughout the year.

Only in the most unusual of businesses would there be a constant need for workingcapital funding. For most businesses there would be weekly fluctuations.

Many businesses operate in industries that have seasonal changes in demand. This meansthat sales, stocks, debtors, etc. would be at higher levels at some predictable times of theyear than at others.

In principle, the working capital need can be separated into two parts:

A fixed part, and

A fluctuatingpart

The fixed part is probably defined in amount as the minimum working capitalrequirement for the year. It is widely advocated that the firm should be funded in the way

shown in the diagram below:

The more permanent needs (fixed assets and the fixed element of working capital) shouldbe financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuatingelement should be financed from a short-term source (e.g. a bank overdraft), which canbe drawn on and repaid easily and at short notice.


7/52

Calculation

Current assets and current liabilities include three accounts which are of specialimportance. These accounts represent the areas of the business where managers have themost direct impact:

accounts receivable (current asset)

inventory (current assets), and

accounts payable (current liability)

The current portion ofdebt (payable within 12 months) is critical, because it represents ashort-term claim to current assets and is often secured by long term assets. Commontypes of short-term debt are bank loans and lines of credit.

An increase in working capital indicates that the business has either increased currentassets (that is has increased its receivables, or other current assets) or has decreased

current liabilities, for example has paid off some short-term creditors.

Implications on M&A: The common commercial definition of working capital for thepurpose of a working capital adjustment in an M&A transaction (i.e. for a working capitaladjustment mechanism in a sale and purchase agreement) is equal to:

Current Assets Current Liabilities excludingdeferred tax assets/liabilities, excess cash,surplus assets and/or deposit balances.

Cash balance items often attract a one-for-one purchase price adjustment.

Working capital management

Decisions relating to working capital and short term financing are referred to as workingcapital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is toensure that the firm is able to continue its operations and that it has sufficient cash flow tosatisfy both maturing short-term debt and upcoming operational expenses.

Decision criteria

By definition, working capital management entails short term decisions - generally,relating to the next one year period - which are "reversible". These decisions are thereforenot taken on the same basis as Capital Investment Decisions (NPV or related, as above)rather they will be based on cash flows and / or profitability.

One measure of cash flow is provided by the cash conversion cycle - the netnumber of days from the outlay of cash for raw material to receiving paymentfrom the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable,and cash. Because this number effectively corresponds to the time that the firm'scash is tied up in operations and unavailable for other activities, managementgenerally aims at a low net count.
http://en.wikipedia.org/wiki/Accounts_receivablehttp://en.wikipedia.org/wiki/Inventoryhttp://en.wikipedia.org/wiki/Accounts_payablehttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Current_assetshttp://en.wikipedia.org/wiki/Current_assetshttp://en.wikipedia.org/wiki/Current_liabilitieshttp://en.wikipedia.org/wiki/M%26Ahttp://en.wikipedia.org/wiki/Deferred_tax_assetshttp://en.wikipedia.org/wiki/Asset#Current_assetshttp://en.wikipedia.org/wiki/Asset#Current_assetshttp://en.wikipedia.org/wiki/Current_liabilityhttp://en.wikipedia.org/wiki/Operations_managementhttp://en.wikipedia.org/wiki/Cash_conversion_cyclehttp://en.wikipedia.org/wiki/Materialhttp://en.wikipedia.org/wiki/Accounts_receivablehttp://en.wikipedia.org/wiki/Inventoryhttp://en.wikipedia.org/wiki/Accounts_payablehttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Current_assetshttp://en.wikipedia.org/wiki/Current_assetshttp://en.wikipedia.org/wiki/Current_liabilitieshttp://en.wikipedia.org/wiki/M%26Ahttp://en.wikipedia.org/wiki/Deferred_tax_assetshttp://en.wikipedia.org/wiki/Asset#Current_assetshttp://en.wikipedia.org/wiki/Asset#Current_assetshttp://en.wikipedia.org/wiki/Current_liabilityhttp://en.wikipedia.org/wiki/Operations_managementhttp://en.wikipedia.org/wiki/Cash_conversion_cyclehttp://en.wikipedia.org/wiki/Material


8/52

In this context, the most useful measure of profitability is Return on capital(ROC). The result is shown as a percentage, determined by dividing relevantincome for the 12 months by capital employed; Return on equity (ROE) showsthis result for the firm's shareholders. Firm value is enhanced when, and if, thereturn on capital, which results from working capital management, exceeds the

cost of capital, which results from capital investment decisions as above. ROCmeasures are therefore useful as a management tool, in that they link short-termpolicy with long-term decision making. See Economic value added (EVA).

Credit policy of the firm: Another factor affecting working capital management iscredit policy of the firm. It includes buying of raw material and selling of finishedgoods either in cash or on credit. This affects the cash conversion cycle.

Management of working capital

Guided by the above criteria, management will use a combination of policies andtechniques for the management of working capital. These policies aim at managing thecurrent assets (generally cash and cash equivalents, inventories and debtors) and theshort term financing, such that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business tomeet day to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows foruninterrupted production but reduces the investment in raw materials - andminimizes reordering costs - and hence increases cash flow. Besides this, the leadtimes in production should be lowered to reduce Work in Progress (WIP) and

similarly, the Finished Goods should be kept on as low level as possible to avoidover production - see Supply chain management; Just In Time (JIT); Economicorder quantity (EOQ); Economic quantity

Debtors management. Identify the appropriate credit policy, i.e. credit termswhich will attract customers, such that any impact on cash flows and the cashconversion cycle will be offset by increased revenue and hence Return on Capital(orvice versa); see Discounts and allowances.

Short term financing. Identify the appropriate source of financing, given thecash conversion cycle: the inventory is ideally financed by credit granted by thesupplier; however, it may be necessary to utilize a bank loan (or overdraft), or to

"convert debtors to cash" through "factoring".

WORKING CAPITAL

Current assets Current liabilities

It measures how much in liquid assets a company has available to build itsbusiness.
http://en.wikipedia.org/wiki/Return_on_capitalhttp://en.wikipedia.org/wiki/Capital_employedhttp://en.wikipedia.org/wiki/Return_on_equityhttp://en.wikipedia.org/wiki/Cost_of_capitalhttp://en.wikipedia.org/wiki/Economic_value_addedhttp://en.wikipedia.org/w/index.php?title=Credit_policy&action=edit&redlink=1http://en.wikipedia.org/wiki/Cash_conversion_cyclehttp://en.wikipedia.org/wiki/Asset#Current_assetshttp://en.wikipedia.org/wiki/Cashhttp://en.wikipedia.org/wiki/Cash_and_cash_equivalentshttp://en.wikipedia.org/wiki/Inventoryhttp://en.wikipedia.org/wiki/Debtorhttp://en.wikipedia.org/wiki/Cash_managementhttp://en.wikipedia.org/wiki/Work_in_progresshttp://en.wikipedia.org/wiki/Finished_goodhttp://en.wikipedia.org/wiki/Supply_chain_managementhttp://en.wikipedia.org/wiki/Just_In_Time_(business)http://en.wikipedia.org/wiki/Economic_order_quantityhttp://en.wikipedia.org/wiki/Economic_order_quantityhttp://en.wikipedia.org/w/index.php?title=Economic_quantity&action=edit&redlink=1http://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Discounts_and_allowanceshttp://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Factoring_(finance)http://en.wikipedia.org/wiki/Return_on_capitalhttp://en.wikipedia.org/wiki/Capital_employedhttp://en.wikipedia.org/wiki/Return_on_equityhttp://en.wikipedia.org/wiki/Cost_of_capitalhttp://en.wikipedia.org/wiki/Economic_value_addedhttp://en.wikipedia.org/w/index.php?title=Credit_policy&action=edit&redlink=1http://en.wikipedia.org/wiki/Cash_conversion_cyclehttp://en.wikipedia.org/wiki/Asset#Current_assetshttp://en.wikipedia.org/wiki/Cashhttp://en.wikipedia.org/wiki/Cash_and_cash_equivalentshttp://en.wikipedia.org/wiki/Inventoryhttp://en.wikipedia.org/wiki/Debtorhttp://en.wikipedia.org/wiki/Cash_managementhttp://en.wikipedia.org/wiki/Work_in_progresshttp://en.wikipedia.org/wiki/Finished_goodhttp://en.wikipedia.org/wiki/Supply_chain_managementhttp://en.wikipedia.org/wiki/Just_In_Time_(business)http://en.wikipedia.org/wiki/Economic_order_quantityhttp://en.wikipedia.org/wiki/Economic_order_quantityhttp://en.wikipedia.org/w/index.php?title=Economic_quantity&action=edit&redlink=1http://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Discounts_and_allowanceshttp://en.wikipedia.org/wiki/Loanhttp://en.wikipedia.org/wiki/Factoring_(finance)


9/52

A short term loan which provides money to buy earning assets.

Allows to avail of unexpected opportunities.

Positive working capital is required to ensure that a firm is able to continue itsoperations and that it has sufficient funds to satisfy both maturing short-term debtand upcoming operational expenses. The management of working capital involves

managing inventories, accounts receivable and payable and cash.

WORKING CAPITAL

An increase in working capital indicates that the business has either increasedcurrent assets (that is received cash, or other current assets) or has decreasedcurrent liabilities, for example has paid off some short-term creditors.

Working Capital Management Decisions relating to working capital and short term financing are referred to as

working capital management. Short term financial management concerned withdecisions regarding to CA and CL.

Management of Working capital refers to management of CA as well as CL. If current assets are less than current liabilities, an entity has a working capital

deficiency, also called a working capital deficit.

These involve managing the relationship between a firm's short-term assets and itsshort-term liabilities.

Working Capital Management

The goal of working capital management is to ensure that the firm is able tocontinue its operations and that it has sufficient cash flow to satisfy both maturingshort-term debt and upcoming operational expenses.

Businesses face ever increasing pressure on costs and financing requirements as a

result of intensified competition on globalize markets. When trying to attaingreater efficiency, it is important not to focus exclusively on income and expenseitems, but to also take into account the capital structure, whose improvement canfree up valuable financial resources

Active working capital management is an extremely effective way to increaseenterprise value. Optimizing working capital results in a rapid release of liquidresources and contributes to an improvement in free cash flow and to a permanentreduction in inventory and capital costs, thereby increasing liquidity for strategicinvestment and debt reduction. Process optimization then helps increaseprofitability.

The fundamental principles of working capital management are reducing thecapital employed and improving efficiency in the areas of receivables,inventories, and payables.

NEED OF WORKING CAPITAL MANAGEMENT


10/52

The need for working capital gross or current assets cannot be over emphasized. Asalready observed, the objective of financial decision making is to maximize theshareholders wealth. To achieve this, it is necessary to generate sufficient profits can beearned will naturally depend upon the magnitude of the sales among other things butsales can not convert into cash. There is a need for working capital in the form of current

assets to deal with the problem arising out of lack of immediate realization of cashagainst goods sold. Therefore sufficient working capital is necessary to sustain salesactivity. Technically this is refers to operating or cash cycle. If the company has certainamount of cash, it will be required for purchasing the raw material maybe available oncredit basis. Then the company has to spend some amount for labour and factoryoverhead to convert the raw material in work in progress, and ultimately finished goods.These finished goods convert in to sales on credit basis in the form of sundry debtors.Sundry debtors are converting into cash after expiry of credit period. Thus some amountof cash is blocked in raw materials, WIP, finished goods, and sundry debtors and day today cash requirements. However some part of current assets may be financed by thecurrent liabilities also. The amount required to be invested in this current assets is always

higher than the funds available from current liabilities. This is the precise reason why theneeds for working capital arise

GROSS WORKING CAPITAL AND NET WORKING CAPITAL

There are two concepts of working capital management

1. Gross working capital

Gross working capital refers to the firms investment I current assets. Current assets arethe assets which can be convert in to cash within year includes cash, short term securities,debtors, bills receivable and inventory.

2. Net working capitalNet working capital refers to the difference between current assets and current liabilities.Current liabilities are those claims of outsiders which are expected to mature for paymentwithin an accounting year and include creditors, bills payable and outstanding expenses.Net working capital can be positive or negative efficient working capital managementrequires that firms should operate with some amount of net working capital, the exactamount varying from firm to firm and depending, among other things; on the nature ofindustries.net working capital is necessary because the cash outflows and inflows do notcoincide. The cash outflows resulting from payment of current liabilities are relativelypredictable. The cash inflow are however difficult to predict. The more predictable thecash inflows are, the less net working capital will be required. The concept of workingcapital was, first evolved by Karl Marx. Marx used the term variable capital meansoutlays for payrolls advanced to workers before the completion of work. He comparedthis with constant capital which according to him is nothing but dead labour. Thisvariable capital is nothing wage fund which remains blocked in terms of financialmanagement, in working process along with other operating expenses until it is releasedthrough sale of finished goods. Although Marx did not mentioned that workers also gave


11/52

credit to the firm by accepting periodical payment of wages which funded a portioned ofW.I.P, the concept of working capital, as we understand today was embedded in hisvariable capital.

TYPES OF WORKING CAPITAL

The operating cycle creates the need for current assets (working capital).However theneed does not come to an end after the cycle is completed to explain this continuing needof current assets a destination should be drawn between permanent and temporaryworking capital.

1) Permanent working capital

The need for current assets arises, as already observed, because of the cash cycle. Tocarry on business certain minimum level of working capital is necessary on continues anduninterrupted basis. For all practical purpose, this requirement will have to be metpermanent as with other fixed assets. This requirement refers to as permanent or fixed

working capital

2) Temporary working capital

Any amount over and above the permanent level of working capital is temporary,fluctuating or variable, working capital. This portion of the required working capital isneeded to meet fluctuation in demand consequent upon changes in production and salesas result of seasonal changes Graph shows that the permanent level is fairly castanet;while temporary working capital is fluctuating in the case of an expanding firm thepermanent working capital line may not be horizontal. This may be because of changes indemand for permanent current assets might be increasing to support a rising level of

activity.


12/52

DETERMINANTS OF WORKING CAPITAL

The amount of working capital is depends upon a following factors:

1. Nature of business

Some businesses are such, due to their very nature, that their requirement of fixed capitalis more rather than working capital. These businesses sell services and not thecommodities and that too on cash basis. As such, no founds are blocked in pilinginventories and also no funds are blocked in receivables. E.g. public utility services likerailways, infrastructure oriented project etc. there requirement of working capital is less.On the other hand, there are some businesses like trading activity, where requirement offixed capital is less but more money is blocked in inventories and debtors.

2. Length of production cycle

In some business like machine tools industry, the time gap between the acquisition of rawmaterial till the end of final production of finished products itself is quit high. As suchamount may be blocked either in raw material or work in progress or finished goods oreven in debtors. Naturally there need of working capital is high.

3. Size and growth of business

In very small company the working capital requirement is quit high due to high overhead,higher buying and selling cost etc. as such medium size business positively has edge overthe small companies. But if the business start growing after certain limit, the workingcapital requirements may adversely affect by the increasing size.

4. Business/ Trade cycle

If the company is the operating in the time of boom, the working capital requirement maybe more as the company may like to buy more raw material, may increase the productionand sales to take the benefit of favorable market, due to increase in the sales, there maymore and more amount of funds blocked in stock and debtors etc. similarly in the case ofdepressions also, working capital may be high as the sales terms of value and quantitymay be reducing, there may be unnecessary piling up of stack without getting sold, thereceivable may not be recovered in time etc.

5. Terms of purchase and sales

Some time due to competition or custom, it may be necessary for the company to extendmore and more credit to customers, as result which more and more amount is locked upin debtors or bills receivables which increase the working capital requirement. On theother hand, in the case of purchase, if the credit is offered by suppliers of goods andservices, a part of working capital requirement may be financed by them, but it isnecessary to purchase on cash basis, the working capital requirement will be higher.


13/52

6. Profitability

The profitability of the business may be vary in each and every individual case, which isin turn its depend on numerous factors, but high profitability will positively reduce the

strain on working capital requirement of the company, because the profits to the extendthat they earned in cash may be used to meet the working capital requirement of thecompany.

7. Operating efficiency

If the business is carried on more efficiently, it can operate in profits which may reducethe strain on working capital; it may ensure proper utilization of existing resources byeliminating the waste and improved coordination etc.

COMPONENTS OF WORKING CAPITAL

Cash

Cash is probably the least productive asset you can have. Not only does it notearn anything, it actually loses purchasing power as a consequence of inflation. So whydo firms hold cash? The three Keynsian motives for holding cash balances are

Transactions motive to conduct day-to-day business of paying forpurchases, labor, etc.

Precautionary motive to cover unexpected expenditures. If the delivery

truck breaks down, it must be repaired or replaced if you want to stay inbusiness.

Speculative motive unusually good opportunities occasionally arise. Ifyou have the money available, you can take advantage of these opportunities.

While cash is necessary to cover the transactions motive, the precautionary andspeculative motives can be covered with the near money (or near cash) of marketablesecurities.

In order to maximize your cash balances, you can do one of two things; eitheraccelerate the inflow of funds (ask for an advance on your salary) or delay the outflow of

funds (postpone paying the phone bill until next month). But why would we want tomaximize our cash holdings if it is the least productive asset? Because idle cash, eithersitting in a checking account or tied-up in accounts receivable is extremely costly.

For example, suppose we have a client who owes us payment of $1,000,000 thatis due. The opportunity cost of not collecting is the interest we could earn on the money.

$1,000,000 Receivable due


14/52

5% Treasury bill rate$ 50,000 Annual interest$50,000/365 days = $137 per day

Can you invest money for one day? Absolutely. In fact, for a large enough amount of

money, someone will meet you at the bank on Sunday in order to accept your deposit.

This also illustrates the concept of float. Bank float is the period of timebetween when a check is written to pay an obligation and when the funds are actuallydeducted from your checking account. Within a city, it is common practice to have alocal check clearing system where banks meet each day to exchange checks written onone anothers accounts. When the bank where a check is deposited is in a different cityfrom the bank on which the check is drawn, the deposited check first goes to the regionalFederal Reserve Bank, (Dallas in the case of Texas), and is then forwarded to the issuingbank. This adds a day or two to the float period. If the check is drawn on a bank accountin another Federal Reserve District, then another day or so is added as the local Fed must

forward the check to the Fed in the issuing banks district which then forwards the checkto the bank. Exxon used to pay suppliers west of the Mississippi river with checkswritten on a small bank in North Carolina, while suppliers east of the Mississippi werepaid with checks on a small bank in Arizona. One days worth of float to the U.S.government is worth over $1 billion (which is one reason government employees now getpaid on the first of the following month rather than the last day of the month).

Most of us have probably played the float on at least one occasion (and probablygotten caught!) It should be noted, however, that using float to cover up a deficit (i.e.,hot check) is illegal.

Another means of extending the float is through the use of drafts. A draft is like acheck, but must be returned to the issuer for verification prior being deposited. This,again, adds 2-3 days to the float period. Insurance companies are most noted for usingdrafts within the U.S. The type of draft that insurance companies use are known assightdrafts since they are paid upon presentation. Time drafts are those which are payableupon a specific future date. Time drafts are an important financing instrument ininternational trade and will be discussed later.

While bank float and drafts delay the outflow of funds, cash balances can also beincreased by speeding up the inflow of funds. The primary means of accomplishing thisis through the use of a lock-box system. A lock-box is a post office box in a local citywhere payments from customers in the area are sent. The lock-box is cleared daily andthe checks are deposited in a local bank and then wired to the companys main bankaccount. Referred to as concentration banking, it cuts 2-3 days off of the time it takes thechecks to cross several states and allows funds to be concentrated in one bank forinvestment in short-term securities. The larger amount of funds that can be investedyields higher interest rates and lower transactions costs.


15/52

The local bank will offer the lock-box system if a local office is not available ordoes not want to devote the personnel to tend to the system. Banks, however, charge forthe services that they provide through either a direct service charge, or by requiring that aminimum compensating balance be maintained. A compensating balance is one that doesnot pay any interest. The minimum balance can be either an absolute minimum or an

average minimum.

Marketable Securities

Marketable securities are a way of holding cash but with the attribute of earninginterest. Market securities have three characteristics:

1. Short-term maturity (less than one year, or money market instruments2. High marketability3. Virtually no risk of default

Several types of marketable securities exist, the major ones being

U.S. Treasury bills

Treasury bills are auctioned every Monday by the government. Most havematurities of 91 or 181 days, although some 9-month (270 days) and 12-month (360 days) bills are sold. The t-bills, generally with a face value of$10,000 each, are sold at a discount to the highest bidders. The differencebetween the amount paid and the face value at maturity represents theinterest that is earned.

Anticipation notes

Anticipation notes are issued by municipalities and school districts. Sincetheir revenues come from tax sources, the notes are in anticipation offuture tax receipts.

Commercial paper

Commercial paper is the promissory notes of a major national firms. Mostof the firms that issue commercial paper sell it directly to investors(insurance companies, money market funds, pension funds) althoughsometimes it will be sold through investment bankers. Commercial paperis a substitute for bank debt, but at a rate of interest that is one-fourth toon-half of a percent higher than t-bills (currently about 4.3%) but

significantly less than what banks would charge (prime is currently about8.5%).

Bankers Acceptances

A bankers acceptance is a time draft that evolves from internationalexport/import financing. An exporter is paid by a time draft issued by aforeign bank. Since the draft is not payable until some future date (1-3months, typically) the company that receives it will often sell it to its local


16/52

bank at a discount. The local bank bundles the discounted drafts (bankersacceptances) and then resells them in the money markets.

Accounts Receivable

Accounts receivable are generated when a firm offers credit to its customers. Thefirst thing that needs to be addressed when establishing a credit policy is to set thestandards by which a firm is judged in determining whether or not credit will beextended. There is whats known as the 5 Cs of credit:

1. Character the willingness of the borrower to repay the obligation2. Capacity the capability of the borrower to earn the money to repay theobligation3. Capital sufficient assets available to support operations (as opposed to afirm that is undercapitalized). Sometimes capital is interpreted to mean equity

capital; i.e., to make sure the owners of the firm have sufficient money atstake to give them proper incentive to repay the loan and not let the companygo bankrupt.4. Collateral assets to support the loan which can be liquidated if defaultoccurs5. Conditions current and future anticipated conditions of the firm and theindustry.

Once the credit standards have been set, the terms of credit need to be established.When must the customer pay? If they pay early, will they receive a discount? If they paylate, do they get charged a penalty?

While the whole purpose of extending credit is to increase sales and, thus, grossprofits, the expected increase in gross profits must be compared with the costs associatedwith extending credit to customers. These costs include

The time value of money tied up in accounts receivable

Bad debts that occur

Credit checks (to minimize bad debts)

Collection costs

Discounts for early payment (reduces revenues)

Clerical costs associated with maintaining a credit department

Competitors will respond very quickly to a change in price. How many timeshave we seen the claims that We will meet or beat any advertised price? A change incredit policy, on the other hand, is a more subtle means of competing for customers andone that the competition will not necessarily respond to. In fact, many firms base theirbusiness on easy credit. How many times have we seen the advertisements where theytell us Good credit? Bad credit? No credit? We dont care! Of course, these firms


17/52

will have larger bad debt expenses and larger financing costs, etc. Obviously, they willalso need to have higher prices (higher gross profit margins) in order to cover these costs.

Inventories

Inventories (raw materials, work-in-process, finished goods) make up a largeportion of most firms current assets, and for many, total assets. As such, the extent towhich a firm efficiently manages its inventories can have a large influence on itsprofitability. Thus, keeping abreast of inventory policy is critical to the profitability (andvalue) of the firm.

Several factors influence the amount of inventory that a firm maintains. The mostimportant of these include

Level of sales typically, the more sales a firm has, the more inventory it

holds Length of time and technical nature of the production process Thelonger it takes to produce finished goods inventories from raw materials, thelarger the amount of finished goods that a firm will typically hold (a safetystock). Also, if the production process is highly technical, requiring thatretooling be performed prior to each production run in order to assure thatproduction is meeting specifications, larger amounts of inventory will beproduced with each production run in order to minimize the set-up costsassociated with retooling. Durability vs. Perishability If an inventory item is highly perishable,such as fresh vegetables, a small amount will be held. Similarly, fashions ofclothes and car styles are perishable and will result in smaller inventoriesthan durable goods such as tools and hardware. Costs Cost of holding inventories as well as costs of obtaininginventories will influence inventory sizes.

Inventory costs can be broken down into three major categories:

A. Ordering Costs

1. Fixed costs stocking, clerical2. Shipping costs often fixed3. Missed quantity discounts an opportunity cost

B. Carrying Costs

1. Time value of money tied-up in inventories2. Warehousing costs3. Insurance4. Handling5. Obsolescence, breakage, shrinkage


18/52

C. Stock-out Costs

1. Lost sales2. Loss of goodwill3. Special shipping costs

Ideally, we want to balance these costs against each other so that our total costsare minimized.

Short-term Financing

Trade Credit

The major source of short-term financing for firms is that of trade credit. While itis an account payable on our balance sheet, it is an account receivable on the balancesheet of our supplier.

The terms of credit can vary quite a bit:

1. Cash on Delivery (i.e., no credit)2. Net amount due within a certain period of time3. Net amount with a discount if paid within a certain period of time, netamount within another period.

For example, 2/10 net 30 means that if you pay within the first ten days, you candeduct 2% from the bill; otherwise the full amount of the bill is due within 30 days.Discounts are offered by suppliers to keep their A/R balances down and minimize thefunds that are tied-up.

Not taking the discount can be a very expensive means of financing. Forexample, suppose we do not pay within the first ten days. Then, if we pay on the thirtiethday, we have paid 2% (approximately) for an additional twenty days use of the funds(the first ten days were free anyway). Since there are 18 twenty-day periods in a year,this is approximately

2% * 18 = 36%

Actually, the cost is a little higher since we are paying 2% on top of the 98% we wouldotherwise have to pay:

2

98

360

2036 7

%

%* . %

days

days=

Of course, if you miss payment by day 10 for taking the discount, dont pay the fullamount of day 11 or you have paid


19/52

2%*360 = 720%

Do banks charge 36% interest on loans? Not in Texas or most states. It is a violation ofthe usury laws. Then why do many companies forego the discounts if the cost is so high?It is the only source of funding that they can get. To reduce the effective cost, firms will

often stretch payment out past the due date. Of course, this subjects the firm to risk of itscredit being completely cut off by the supplier and possibly damages the credit reputationsince other suppliers will often request references before extending credit themselves.

Some firms will offer post-dated billing, typically in a seasonal industry. Forexample, if a manufacturers primary sales are to retailers for the Christmas season theymay encourage retailers to order in June and July rather than waiting until September.The encouragement is that if an order is placed in June or July, the manufacturer will notbill them until September and even then regular credit terms will apply. The advantagehere is that it allows the manufacturer to smooth out sale and thus production. Themanufacturer can then save on overtime with employees as well as not incur many of the

carrying costs associated with holding the inventories since the retailer takes possessionand ownership earlier.

Commercial Banks

The second major source of short-term financing for firms is commercial banks.A firm wants to establish a close relationship with its bank and obtain a line of credit. Inorder to get a credit line, you will want to show them your income statements, balancesheets, financial ratios, etc. The bank will then allow a certain amount of credit with a setrate of interest (usually prime plus). This can be renegotiated every year. In fact,commercial banks bread and butter is their business accounts and they are verycompetitive with one another in trying to attract corporate clients. The amount of thecredit line is typically tied to the amount of accounts receivable that the firm has andsometimes to the amount of inventories that it holds.

Another type of credit line is referred to as a revolving line of credit. With arevolving line of credit, the bank provides a written agreement guaranteeing loans up to acertain amount. The firm will pay a normal rate of interest on the amounts of funds thatit borrows plus a commitment fee of one-half to one percent on any unborrowed funds.Unlike a regular line of credit which can be changed, a revolving line of credit guaranteesthat the bank will always make the amount available if needed. Additionally, a revolvingline of credit will often be extended jointly by several banks when the amounts used arelarger than a single bank can (or wants to) handle alone.

Types of Loans

Loans come in a variety of shapes. Asimple loan requires that the firm maintaina non-interest-bearing account at the bank. While compensating balances are not used asmuch as they have been in the past, they are still encountered frequently.


20/52

Suppose a bank offers a one-year loan for $100,000 at an 8% rate of interest witha compensating balance of 20%. Then,

$100,000 loanLess: 20,000 compensating balance

$ 80,000 net proceeds

At the end of one year, the firm repays the bank $88,000. $8,000 is interest on the loanand the other $80,000 (with the $20,000 in the compensating balance for a total of$100,000) is the principal. Thus, the firm has effectively paid $8,000 interest on the useof $80,000 for an annual rate of interest of 10%.

Alternatively, the bank may offer a discounted loan where the interest is deductedup-front. Using our same example,

$100,000 loan

Less: 8,000 interest$ 92,000 net proceeds

At the end of the year, the firm repays the $100,000 of principal (since the interest waspaid up-front). Effectively, the firm paid $8,000 of interest for the use of $92,000 offunds for a rate of interest of 8.7% on the loan.

Of course, your banker is there to help you and may express concern that the needto come up with $100,000 at the end of the year could be difficult. He/she may suggest,instead, an interest add-on loan where the amount of interest is added to the principal andthen repaid in a series of installments. Our example loan would then required thatmonthly payments of $9,000 be made ($100,000 principal + $8,000 interest =$108,000/12 months = $9,000 per month).

$100,000

AverageOwed

12 months


21/52

As an approximation, the amount of the loan that was outstanding during the yearwas, on average, only $50,000. The $8,000 of interest thus represents an approximately16% rate of interest on the average amount of the loan.

More precisely, this loan appears as

0 1 - - - - - - - - - - - - - - - - - 11 12

100,000 (9,000) - - - - - - - - - - - - - - (9,000) (9,000)

Of course, if you were the bank, the cash flows would be the same, only the signswould be reversed. So as a bank officer, how would you determine the rate of interestthat you were earning on this investment?

The true cost of debt ofany loan is the internal rate of return between what you

receive and what you have to pay back. Suppose we use our calculators and determinethe IRR of this interest add-on loan. We determine that the IRR is 1.2%. But rememberthat his is 1.2% per month. Using simple interest, 1.2%*12 = 14.4% annual rate ofinterest.

Security for Bank Loans

Banks like some sort of collateral for loans to ensure repayment of the loan, atleast in part. The preferred collateral for bank loans is accounts receivable. The reason,of course, is that collecting money is what banks do. Typically, a bank will loan up to75-80% of the receivables that are not over 60 days. There are two ways to obtainfinancing with receivables:

Pledging of Accounts Receivable This is the most common form. A lender willloan up to 80% of the amount of the invoice. Upon payment, the borrower has pledgedto use the proceeds to reduce the amount of the loan. If the customer does not pay theinvoice, the borrower is still obligated to repay the loan.

Factoring of Accounts Receivable The receivable is sold to a factoringinstitution. Typically, this is used prior to making a sale on credit. The seller will go to afactor who will run a credit check on the potential buyer. If the buyer has a good creditrating, the factor will give the go-ahead to sell on credit and then buy the receivable (at adiscount) from the seller. The buyer is notified in writing to pay the factor directly forthe receivable. Then, if the invoice is not paid, it is up to the factor to collect from thebuyer and the factor takes the risk of bad debt. Sometimes, the factor may withhold 10%from the seller to make them share in the risk of non-payment. Then, when payment isreceived, the 10% reserve will be refunded to the seller.

The use of factoring is considerably more expensive than the pledging of accountsreceivable. This is due to the fact that, in addition to lending money for a period of 30-90


22/52

days, the factor also must run a credit check, incur the cost of collection, and undertakethe risk of nonpayment.

Banks will also use inventories as collateral for short-term loans. A blanket lien(or floating lien) is one that covers all inventories. Even then, the lender will only loan

40-50% of the cost of those goods. This is because, if default occurs, the lender will haveto hire someone to sell the inventories as well as substantially discounting them in orderto liquidate the inventories.

A warehouse receipts loan is where a third party holds the inventory as collateralfor the lender. A warehouse receipts loan is most commonly used in the canning industryor where production of inventory is seasonal. For example, the cotton season runs fromJune to October. Denim jeans, on the other hand, are purchased year-round. Thus, adenim manufacturer might buy cotton in June and produce denim but not have enough forthe estimated annual demand. The producer could then go to a bank and borrow againstthe bolts of denim that have been produced. These bolts of denim would then be stored

in a public warehouse as collateral and funds would be made available for the producer topurchase more cotton and produce more denim. As inventories are sold, the loan couldbe paid down, in which case the lender would notify the public warehousing company torelease X number of bolts of denim to the producer and the process reverses itself.

If the inventories are too bulky to transport to a public warehouse, a fieldwarehouse arrangement may be set up where the public warehousing company goes tothe producers place of business and physically segregates the inventories that are beingheld as collateral for the lender. Only the public warehousing company would haveaccess to the collateral and would only release it upon notification by the lender.

Securities Loans

A borrower can pledge their inventories of securities of another company (bonds,notes payable) as collateral for a loan as well. Thus, if you hold a note payable from acreditworthy firm, many lenders will loan money against it. (This is similar, in a sense,to what happens with a margin purchase.)

In short, if a firm has assets of virtually any kind, it can use them as collateral forshort-term loans to meet its short-term cash needs.

Importance of working capital management?

The term working capital refers to the amount of capital which is readily available to acompany. That is, working capital is the difference between resources in cash or readilyconvertible into cash (Current Assets) and organizational commitments for which cashwill soon be required (Current Liabilities).

Current Assets are resources which are in cash or will soon be converted into cash in "theordinary course of business".


23/52

Current Liabilities are commitments which will soon require cash settlement in "theordinary course of business".

Thus:WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

In a company's balance sheet components of working capital are reported under thefollowing headings:

Current Assets:

Liquid Assets (cash and bank deposits)InventoryDebtors and Receivables

Current Liabilities:

Bank OverdraftCreditors and Payables

Other Short Term Liabilities

The Importance of Good Working Capital Management

From a company's point of view, excess working capital means operating inefficiencies.Money that is tied up in inventory or money that customers still owe to the companycannot be used to pay off any of the company's obligations. So, if a company is notoperating in the most efficient manner (slow collection), it will show up as an increase inthe working capital. This can be seen by comparing the working capital from one periodto another; slow collection may signal an underlying problem in the company's

operations.

Approaches to Working Capital Management

The objective of working capital management is to maintain the optimum balance of eachof the working capital components. This includes making sure that funds are held as cashin bank deposits for as long as and in the largest amounts possible, thereby maximizingthe interest earned. However, such cash may more appropriately be "invested" in otherassets or in reducing other liabilities.In recent years there has been an increased focus on Dynamic Discounting as a means ofoptimizing Working Capital. This methods involves the early payment for goods and

services bought in return for a discounted price. Operated properly, this can give asignificant return on working capital.

Working capital management takes place on two levels:

* Ratio analysis can be used to monitor overall trends in working capital and to identifyareas requiring closer management


24/52

* The individual components of working capital can be effectively managed by usingvarious techniques and strategies

When considering these techniques and strategies, companies need to recognize that each

department has a unique mix of working capital components. The emphasis that needs to be placed on each component varies according to department. For example, somedepartments have significant inventory levels; others have little if any inventory.

Furthermore, working capital management is not an end in itself. It is an integral part ofthe department's overall management. The needs of efficient working capitalmanagement must be considered in relation to other aspects of the department's financialand non-financial performance.

The working capital needs of a business are influenced by numerous

factors.The important ones are discussed in brief as given below:

i. Nature of EnterpriseThe nature and the working capital requirements of an enterprise are interlinked. While amanufacturing industry has a long cycle of operation of the working capital, the samewould be short in an enterprise involved in providing services. The amount required alsovaries as per the nature; an enterprise involved in production would require more workingcapital than a service sector enterprise.

ii. Manufacturing/Production Policy

Each enterprise in the manufacturing sector has its own production policy, some followthe policy of uniform production even if the demand varies from time to time, and othersmay follow the principle of 'demand-based production in which production is based onthe demand during that particular phase of time. Accordingly, the working capitalrequirements vary for both of them.

iii. OperationsThe requirement of working capital fluctuates for seasonal business. The working capitalneeds of such businesses may increase considerably during the busy season and decreaseduring the slack season. Ice creams and cold drinks have a great demand during summers,while in winters the sales are negligible.

iv. Market ConditionIf there is high competition in the chosen product category, then one shall need to offersops like credit, immediate delivery of goods etc. for which the working capitalrequirement will be high. Otherwise, if there is no competition or less competition in themarket then the working capital requirements will be low.

v. Availability of Raw Material


25/52

If raw material is readily available then one need not maintain a large stock of the same,thereby reducing the working capital investment in raw material stock. On the other hand,if raw material is not readily available then a large. Inventory/stock needs to bemaintained, thereby calling for substantial investment in the same.

vi. Growth and ExpansionGrowth and expansion in the volume of business results in enhancement of the workingcapital requirement. As business grows and expands, it needs a larger amount of workingcapital. Normally, the need for increased working capital funds precedes growth inbusiness activities.

vii. Price Level ChangesGenerally, rising price level requires a higher investment in the working capital. Withincreasing prices, the same level of current assets needs enhanced investment.

viii. Manufacturing Cycle

The manufacturing cycle starts with the purchase of raw material and is completed withthe production of finished goods. If the manufacturing cycle involves a longer period, theneed for working capital would be more. At times, business needs to estimate therequirement of working capital in advance for proper control and management. Thefactors discussed above influence the quantum of working capital in the business. Theassessment of working capital requirement is made keeping these factors in view. Eachconstituent of working capital retains its form for a certain period and that holding periodis determined by the factors discussed above. So for correct assessment of the workingcapital requirement, the duration at various stages of the working capital cycle isestimated. Thereafter, proper value is assigned to the respective current assets, dependingon its level of completion. The basis for assigning value to each component is givenbelow:

Each constituent of the working capital is valued on the basis of valuation enumeratedabove for the holding period estimated. The total of all such valuation becomes the total


26/52

estimated working capital requirement. The assessment of the working capital should beaccurate even in the case of small and micro enterprises where business operation is notvery large. We know that working capital has a very close relationship with day-to-dayoperations of a business. Negligence in proper assessment of the working capital,therefore, can affect the day-to-day operations severely. It may lead to cash crisis and

ultimately to liquidation. An inaccurate assessment of the working capital may causeeither under-assessment or over-assessment of the working capital and both of them aredangerous.

CONSEQUENCES OF UNDER ASSESSMENT OF WORKING CAPITAL

Growth may be stunted. It may become difficult for the enterprise to undertakeprofitable projects due to non-availability of working capital.

Implementation of operating plans may become difficult and consequently theprofit goals may not be achieved.

Cash crisis may emerge due to paucity of working funds.

Optimum capacity utilization of fixed assets may not be achieved due to non-availability of the working capital.

The business may fail to honour its commitment in time, thereby adverselyaffecting its credibility. This situation may lead to business closure.

The business may be compelled to buy raw materials on credit and sell finishedgoods on cash. In the process it may end up with increasing cost of purchases andreducing selling prices by offering discounts.Both these situations would affect profitability adversely.

Non-availability of stocks due to non-availability of funds may result inproduction stoppage.

While underassessment of working capital has disastrous implications on

business, over assessment of working capital also has its own dangers.

CONSEQUENCES OF OVER ASSESSMENT OF WORKING CAPITAL

Excess of working capital may result in unnecessary accumulation of inventories.

It may lead to offer too liberal credit terms to buyers and very poor recoverysystem and cash management.

It may make management complacent leading to its inefficiency.

Over-investment in working capital makes capital less productive and may reducereturn on investment.

Working capital is very essential for success of a business and, therefore, needs efficientmanagement and control. Each of the components of the working capital needs propermanagement to optimize profit.

Inventory Management

Inventory includes all types of stocks. For effective working capital management,inventory needs to be managed effectively. The level of inventory should be such that thetotal cost of ordering and holding inventory is the least. Simultaneously, stock out costs


27/52

should also be minimized. Business, therefore, should fix the minimum safety stock level,re-order level and ordering quantity so that the inventory cost is reduced and itsmanagement becomes efficient.

Receivables Management

Given a choice, every business would prefer selling its produce on cash basis. However,due to factors like trade policies, prevailing marketing conditions, etc., businesses arecompelled to sell their goods on credit. In certain circumstances, a business maydeliberately extend credit as a strategy of increasing sales. Extending credit meanscreating a current asset in the form of Debtors or Accounts Receivable. Investment inthis type of current assets needs proper and effective management as it gives rise to costssuch as:

i. Cost of carrying receivable (payment of interest etc.)ii. Cost of bad debt lossesThus the objective of any management policy pertaining to accounts receivables would

be to ensure that the benefits arising due to the receivables are more than the costincurred for receivables and the gap between benefit and cost increases resulting inincreased profits. An effective control of receivables helps a great deal in properlymanaging it. Each business should, therefore, try to find out average credit extended to itsclient using the below given formula:

Each business should project expected sales and expected investment in receivablesbased on various factors, which influence the working capital requirement. From this itwould be possible to find out the average credit days using the above given formula. Abusiness should continuously try to monitor the credit days and see that the average creditoffered to clients is not crossing the budgeted period. Otherwise, the requirement ofinvestment in the working capital would increase and, as a result, activities may getsqueezed. This may lead to cash crisis.

Cash Management

Cash is the most liquid current asset. It is of vital importance to the daily operations of

business. While the proportion of assets held in the form of cash is very small, itsefficient management is crucial to the solvency of the business. Therefore, planning cashand controlling its use are very important tasks. Cash budgeting is a useful device for thispurpose.

Cash Budget

Cash budget basically incorporates estimates of future inflows and outflows of cash overa projected short period of time which may usually be a year, a half or a quarter year.


28/52

Effective cash management is facilitated if the cash budget is further broken down intomonth, week or even on daily basis.There are two components of cash budget (i) cash inflows and (ii) cash outflows.The main sources for these flows are given hereunder:

Cash Inflows(a) Cash sales(b) Cash received from debtors(c) Cash received from loans, deposits, etc.(d) Cash receipt of other revenue income(e) Cash received from sale of investments or assets.

Cash Outflows(a) Cash purchases

(b) Cash payment to creditors(c) Cash payment for other revenue expenditure

(d) Cash payment for assets creation(e) Cash payment for withdrawals, taxes(f) Repayment of loans, etc.A suggestive format for Cash Budget is given below


29/52

Financing Working Capital

Now let us understand the means to finance the working capital. Working capital orcurrent assets are those assets, which unlike fixed assets change their forms rapidly. Dueto this nature, they need to be financed through short-term funds. Short-term funds arealso called current liabilities. The following are the major sources of raising short-term

funds:

i. Suppliers Credit

At times, business gets raw material on credit from the suppliers. The cost of rawmaterial is paid after some time, i.e. upon completion of the credit period. Thus, withouthaving an outflow of cash the business is in a position to use raw material and continuethe activities. The credit given by the suppliers of raw materials is for a short period and


30/52

is considered current liabilities. These funds should be used for creating current assetslike stock of raw material, work in process, finished goods, etc.

ii. Bank Loan for Working Capital

This is a major source for raising short-term funds. Banks extend loans to businesses to

help them create necessary current assets so as to achieve the required business level. Theloans are available for creating the following current assets:

Stock of Raw Materials

Stock of Work in Process

Stock of Finished Goods

DebtorsBanks give short-term loans against these assets, keeping some security margin.The advances given by banks against current assets are short-term innature and banks have the right to ask for immediate repayment if they considerdoing so. Thus bank loans for creation of current assets are also current

liabilities.

iii. Promoters Fund

It is advisable to finance a portion of current assets from the promoters funds.They are long-term funds and, therefore do not require immediate repayment.These funds increase the liquidity of the business.

Why working Capital is important?

Investment in CA represents a substantial portion of total investment.

Investment in CA and level of CL have to be geared quickly to changes in sales


31/52

Concepts of Working Capital

Gross Working Capital

Net working Capital

Gross Working Capital

Total Current assets

Where Current assets are the assets that can be converted into cash within anaccounting year & include cash , debtors etc.

Referred as Economics Concept since assets are employed to derive a rate ofreturn

.Net Working Capital

CA CL

Referred as point of view of an Accountant.

It indicates liquidity position of a firm & suggests the extent to which working

capital needs may be financed by permanent sources of funds.

CONSTITUENTS OF WORKING CAPITAL

CURRENT ASSETS

Inventory

Sundry Debtors

Cash and Bank Balances


32/52

Loans and advances

CURRENT LIABILITIES

Sundry creditors

Short term loans

Provisions

Characteristics of Current Assets

Short Life SpanI.e. cash balances may be held idle for a week or two , thus a/c may have a life span of

30-60 days etc.

Swift Transformation into other Asset formsI.e. each CA is swiftly transformed into other asset forms like cash is used for acquiring

raw materials , raw materials are transformed into finished goods and these sold on creditare convertible into A/R & finally into cash.

Matching Principle

If a firm finances a long term asset(like machinery) with a S-T Debt then it willhave to be periodically finance the asset which will be risky as well asinconvenient.

i.e. maturity of sources of financing should be properly matched with maturity ofassets being financed.

Thus Fixed Assets & permanent CA should be supported with L-T sources offinance & fluctuating CA by S-T sources.

MATCHING PRINCIPLE

Need for Working Capital


33/52

As profits earned depend upon magnitude of sales and they do not convert intocash instantly, thus there is a need for working capital in the form of CA so as todeal with the problem arising from lack of immediate realization of cash againstgoods sold.

This is referred to as Operating or Cash Cycle.

It is defined as The continuing flow from cash to suppliers, to inventory , toaccounts receivable & back into cash .

Thus needs for working capital arises from cash or operating cycle of a firm.

Which refers to length of time required to complete the sequence of events.

Thus operating cycle creates the need for working capital & its length in terms oftime span required to complete the cycle is the major determinant of the firmsworking capital needs.

Operating or Cash Cycle1. Conversion of cash into inventory2. Conversion of inventory into Receivables

3. Conversion of Receivables into Cash

OPERATING CYCLE

Phase 3

Phase 2

Phase 1

TYPES OF WORKING CAPITAL

PERMANENT WORKING CAPITAL

VARIABLE WORKING CAPITAL

PERMANENT WORKING CAPITAL

THERE IS ALWAYS A MINIMUM LEVEL OF CA WHICH ISCONTINOUSLY REQUIRED BY A FIRM TO CARRY ON ITS BUSINESSOPERATIONS.

THUS , THE MINIMUM LEVEL OF INVESTMENT IN CURRENT ASSETSTHAT IS REQUIRED TO CONTINUE THE BUSINESS WITHOUTINTERRUPTION IS REFERRED AS PERMANENT WORKING CAPITAL.

VARIABLE WORKING CAPITAL

CASH

INVENTORY

RECEIVABLES


34/52

THIS IS THE AMOUNT OF INVESTMENT REQUIRED TO TAKE CARE OFFLUCTUATIONS IN BUSINESS ACTIVITY OR NEEDED TO MEETFLUCTUATIONS IN DEMAND CONSEQUENT UPON CHANGES INPRODUCTION & SALES AS A RESULT OF SEASONAL CHANGES.

DISTINCTION PERMANENT IS STABLE OVER TIME WHEREAS VARIABLE IS

FLUCTUATING ACCORDING TO SEASONAL DEMANDS.

INVESTMENT IN PERMANENT PORTION CAN BE PREDICTED WITHSOME PROFITABILITY WHEREAS INVESTMENT IN VARIABLECANNOT BE PREDICTED EASILY.

WHILE PERMANENT IS MINIMUM INVESTMENT IN VARIOUS CA ,VARIABLE IS EXPECTED TO TAKE CARE FOR PEAK IN BUSINESSACTIVITY.

WHILE PERMANENT COMPONENT REFLECTS THE NEED FOR ACERTAIN IRREDUCIBLE LEVEL OF CURRENT ASSETS ON A

CONTINOUS AND UNINTERRUPTED BASIS , THE TEMPORARYPORTION IS NEEDED TO MEET SEASONAL & OTHER TEMPORARYREQUIREMENTS.

ALSO PERMANENT CAPITAL REQUIREMENTS SHOULD BE FINANCEDFROM L-T SOURCES , S-TFUNDS SHOULD BE USED TO FINANCETEMPORARY WORKING CAPITAL NEEDS OF A FIRM,

OPERATING ENVIRONMENT OF WORKING CAPITAL

Monetary and Credit Policies

Monetary policy is the process by which the government, central bank, ormonetary authority of a country controls (i) the supply of money, (ii) availabilityof money, and (iii) cost of money or rate of interest, in order to attain a set ofobjectives oriented towards the growth and stability of the economy.

Monetary policy is the process by which the government, central bank, ormonetary authority of a country controls (i) the supply of money, (ii) availabilityof money, and (iii) cost of money or rate of interest, in order to attain a set ofobjectives oriented towards the growth and stability of the economy. Monetarytheory provides insight into how to craft optimal monetary policy.

Monetary policy involves variations in money supply , interest rates , lending bycommercial banks etc.

Credit Policy

Credit gives the customer the opportunity to buy goods and services, and pay forthem at a later date.

Clear, written guidelines that set(1) the terms and conditions for supplying goods on credit ,(2) customer qualification criteria(3) procedure for making collections , and


35/52

(4) steps to be taken in case of customer delinquency . Also called collection policy.

Where delinquency means Failure to repay an obligation when due or as agreed.Thus in consumer installment loans, missing two successive payments willnormally make the account delinquent

Advantages of credit trade Usually results in more customers than cash trade.

Can charge more for goods to cover the risk of bad debt.

Gain goodwill and loyalty of customers.

People can buy goods and pay for them at a later date.

Farmers can buy seeds and implements, and pay for them only after the harvest.

Stimulates agricultural and industrial production and commerce.

Can be used as a promotional tool.

Increase the sales.

Disadvantages of credit trade

Risk of bad debt.

High administration expenses.

People can buy more than they can afford.

More working capital needed.

Risk of Bankruptcy

Instruments of Monetary Policy in India Money Supply

Bank Rate

Reserve Ratios

Interest Rates Selective Credit Controls

Flow of CreditMoney Supply

This is the sum total of money public funds and can be used for settlingtransactions to buy and sell things and make other payments constitutes themoney supply of a nation.

Money supply = Notes and coins with public + Demand deposits withCommercial papers

Bank Rate Standard rate at which bank is prepared to buy or rediscount bills of exchange or

other commercial papers eligible for purchase under Reserve bank of India Act,1934.

The rate of interest charged by central bank on their loans to commercial banks iscalled bank rate (Discount rate).

An increase in bank rate makes it more expensive for commercial banks toborrow . This exerts pressure to bring about the rise in interest rates (lending


36/52

rates) charged by commercial banks on their lending to public. This leads to ageneral tightening in economy.

Whereas decrease in bank rate has the opposite effect and leads to general easingof credit in the economy.

RESERVE REQUIREMENTS The reserve requirement (orrequired reserve ratio) is a bank regulation that

sets the minimum reserves each bank must hold to customer deposits and notes.These reserves are designed to satisfy withdrawal demands, and would normallybe in the form of fiat currency stored in a bank vault(vault cash), or with a centralbank.

The reserve ratio is sometimes used as a tool in the monetary policy, influencingthe country's economy, borrowing, and interest rates .Western central banks rarelyalter the reserve requirements because it would cause immediate liquidityproblems for banks with low excess reserves; they prefer to use open marketoperations to implement their monetary policy

Thus central bank makes it legally obligatory for commercial banks to keep acertain minimum percentage of deposits in reserve.

These are of 2 types:-1. Cash reserves2. Liquidity reserves

CRR

CASH RESERVE RATIO THIS IS DEFINED AS A cash reserve ratio (or CRR) is the percentage of bank

reserves to deposits and notes. The cash reserve ratio is also known as the cashasset ratio orliquidity ratio.

STATUTORY LIQUIDITY RATIO Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in

India. It is the amount which a bank has to maintain in the form:

Cash

Gold valued at a price not exceeding the current market price,

Unencumbered approved securities (G Secs or Gilts come under this) valued at aprice as specified by the RBI from time to time.

STATUTORY LIQUIDITY RATIO

The quantum is specified as some percentage of the total demand and time

liabilities ( i.e. the liabilities of the bank which are payable on demand anytime,and those liabilities which are accruing in one months time due to maturity) of abank. This percentage is fixed by the Reserve Bank of India. The maximum andminimum limits for the SLR are 40% and 25% respectively.

Following the amendment of the Banking regulation Act (1949) in January 2007,the floor rate of 25% for SLR was removed. Presently the SLR is 24% with effectfrom 8 November, 2008.

The objectives of SLR are:


37/52

To restrict the expansion of bank credit.

To augment the investment of the banks in Government securities.

To ensure solvency of banks. A reduction of SLR rates looks eminent to supportthe credit growth in India.

INTEREST RATES This is generally done by stipulating min. rates of interest for extending credit

against commodities covered under selective credit control. Also, concessive or ceiling rates of interest are made applicable to advances for

certain purposes is to certain sectors to reduce the interest burden and thusfacilitate their development.

Further objective behind fixing rates on deposits are to avoid unhealthycompetition amongst the banks for deposits and keep the level of deposit rates inalignment with lending rates of banks for deposits.

Selective Credit Controls

These are Qualitative instruments which are aimed at affecting changes in theavailability of credit with respect to particular sectors of the economy.

Thus selective controls are called selective because they are aimed at movementof credit towards selective sectors of the economy

The general instruments such as Reserve ratios, Bank rate and open marketoperations.

They are called so because they influence the nations money supply and generalavailability of credit.

Quantitative instruments are called quantitative because they affect the totalvolume(quantity) of money supply and credit in the country.

The most widely used qualitative techniques are selective control and moral

suasion. While the general credit controls operate on the cost and total volume of credit,

selective credit controls relate to tools available with the monetary authority forregulating the distribution or direction of bank resources to particular sectors ofeconomy in accordance with broad national priorities considered necessary forachieving the set.

MORAL SUASION

IT IMPLIES THE CENTRAL BANK EXERTING PRESSURE ON BANKS BYUSING ORAL AND WRITTEN APPEALS TO EXPAND OR RESTRICTCREDIT IN LINE WITH ITS CREDIT POLICY.

DETERMINATION OF WORKING CAPITAL NEEDS

Different approaches in determination of working capital

Industry norm approach

Economic modeling approach

Strategic choice approach


38/52

INDUSTRY NORM APPROACH

THIS APPROACH IS BASED ON THE PREMISE THAT EVERY COMPANYIS GUIDED BY THE INDUSTRY PRACTICE.

LIKE IF MAJORITY OF FIRMS HAVE BEEN GRANTING 3 MONTHS

CREDIT TO A CUSTOMER THEN OTHERS WILL HAVE TO ALSOFOLLOW THE MAJORITY DUE TO FEAR OF LOSING CUSTOMERS.

ECONOMIC MODELLING APPROACH

TO ESTIMATE OPTIMUM INVENTORY IS DECIDED WITH THE HELP OFEOQ MODEL.

STRATEGIC CHOICE APPROACH

THIS APPROACH RECOGNISES THE VARIATIONS IN BUSINESSPRACTICE AND ADVOCATES USE OF STRATEGYIN TAKING WORKINGCAPITAL DECISIONS.

THE PURPOSE BEHIND THIS APPROACH IS TO PREPARE THE UNIT TO

FACE CHALLENGES OF COMPETITION & TAKE A STRATEGICPOSITION IN THE MARKET PLACE.

STRATEGIC CHOICE APPROACH

THE EMPHASIS IS ON STRATEGIC BEHAVIOUR OF BUSINESSUNIT.THUS THE FIRM IS INDEPENDENT IN CHOOSING ITS OWNCOURSE OF ACTION WHICH IS NOT GUIDED BY THE RULES OFINDUSTRY,

Determinants of working capital

General nature of business Production cycle

Business cycle

Credit policy

Production policy

Growth and expansion

Profit level

Operating efficiency

FACTORS AFFECTING WORKING CAPITAL

The need of working capital is not always the same. It varies from year to year or evenmonth to month depending upon a number of factors. There are no set rules or formulaeto determine working capital needs of the firm. Each factor has its own importance andthe importance of factor changes for a firm over time. In order to determine the properamount of working capital of a concern, the following factors should be consideredcarefully:-


39/52

Nature of business: The amount of working capital is basically related to the nature andvolume of the business. In concerns where the cost of raw materials to be used in themanufacture of a product is very large in proportion to its total cost of manufacture, therequirements of working capital will be large. On the contrary, concerns having large

investments in fixed assets require lesser amount of working capital.

Size of the business unit: Size of the business unit is also a determining factor inestimating the total amount of working capital. The general principle in this regard is thatthe bigger the size, the larger will be the amount of working capital required since thelarger business units are required to maintain larger inventories for the flow of thebusiness.

Seasonal Variations: Strong seasonal movements create special problems of workingcapital in controlling the financial swings. A great many companies have to carry outseasonal business such as sugar mills, oil mills or woolen mills, etc. and therefore they

require larger amount of working capital in the season to purchase the raw materials inlarge quantities and utilize them throughout the year.Time Consumed in Manufacture: The average time taken in the process of manufactureis also an important factor in determining the amount of working capital. The longer theperiod of manufacture, the larger the inventory required. Though capital goods industriesmanage to minimize their investment in inventories or working capital by askingadvances from the customers as work proceeds on their orders.

Turnover of Circulating Capital: Turnover means the ratio of gross annual sales toaverage working assets. In simple words, it means the speed with which circulatingcapital completes its rounds or the number of times the amount invested in working assetshave been converted into cash by sale of the finished goods and re-invested in workingassets during a year. The faster the sales, the larger the turnover. Conversely, the greaterthe turnover, the larger the volume of business to be done with given working capital.

Labour v/s Capital Intensive Industries: In labour intensive industries, larger workingcapital is required because of regular payment of heavy wage bills and more time taken incompleting the manufacturing process. The capital intensive industries require lesseramount of working capital because of the heavy investment in fixed assets and shorterperiod in manufacturing process.

Need to Stockpile Raw Material and Finished Goods: In industries, where it isnecessary to stockpile the raw materials and finished goods, it increases the amount ofworking capital tied up in stocks and stores. In certain lines of business where thematerials are bulky and best purchased in large quantities such as cement, stockpiling isusual. Such concerns require larger working capital.

Terms of Purchase and Sale: Terms (cash or credit) of purchase and sales also affectthe amount of working capital. If a company purchases all goods in cash and sells itsfinished product on credit also naturally, it will require larger amount of working capital.


40/52

On the contrary, a concern having credit faci

working capital mngt final

Documents