Working Capital Management (BCM)

8/2/2019 Working Capital Management (BCM)

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WORKING CAPITAL

Current assets Current liabilities It measures how much in liquid assets a company has

available to build its business.

Positive working capital is required to ensure that afirm is able to continue its operations and that it has

sufficient funds to satisfy both maturing short-termdebt and upcoming operational expenses. Themanagement of working capital involves managinginventories, accounts receivable and payable andcash.

An increase in working capital indicates that thebusiness has either increased current assets (that isreceived cash, or other current assets) or hasdecreased current liabilities, for example has paid offsome short-term creditors.


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Concept of Working Capital

There are two possible interpretations ofworking capital concept:

Balance sheet concept

Operating cycle concept

Balance sheet concept

There are two interpretations of workingcapital under the balance sheet concept.

Excess of current assets over currentliabilities

gross or total current assets.


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Excess of current assets over currentliabilities are called the net working capital ornet current assets.

Working capital is really what a part of longterm finance is locked in and used forsupporting current activities.

The balance sheet definition of workingcapital is meaningful only as an indication ofthe firms current solvency in repaying itscreditors.

When firms speak of shortage of workingcapital they in fact possibly imply scarcity ofcash resources.

In fund flow analysis an increase in workingcapital, as conventionally defined, representsemployment or application of funds.



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Operating cycle concept A companys operating cycle typically consists of three

primary activities: Purchasing resources, Producing the product and

Distributing (selling) the product.These activities create funds flows that are bothunsynchronized and uncertain.Unsynchronized because cash disbursements (forexample, payments for resource purchases) usuallytake place before cash receipts (for example collection

of receivables).They are uncertain because future sales and costs,which generate the respective receipts anddisbursements, cannot be forecasted with completeaccuracy.



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The firm has to maintain cash balanceto pay the bills as they come due.

In addition, the company must invest ininventories to fill customer orders

promptly. And finally, the company invests in

accounts receivable to extend credit tocustomers.

Operating cycle is equal to the length ofinventory and receivable conversionperiods.



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Inventory conversion period

Avg. inventory= _________________

Cost of sales/365

Receivable conversion period

Accounts receivable= ___________________

Annual credit sales/365

Payables deferral period

Accounts payable + Salaries, etc

= ___________________________

(Cost of sales + selling, general and admn.Expenses)/365



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Cash conversion cycle = operatingcycle payables deferral period.

Importance of working capital Risk and uncertainty involved in

managing the cash flows

Uncertainty in demand and supply ofgoods, escalation in cost both operatingand financing costs.

Strategies to overcome the problem Manage working capital investment or

financing such as



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Holding additional cash balances beyondexpected needs

Holding a reserve of short termmarketable securities

Arrange for availability of additional

short-term borrowing capacity One of the ways to address the problem

of fixed set-up cost may be to holdinventory.

One or combination of the abovestrategies will target the problem

Working capital cycle is the life-bloodof the firm



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FACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry

2. Demand of Industry3. Cash requirements4. Nature of the Business5. Manufacturing time6. Volume of Sales7. Terms of Purchase and Sales8. Inventory Turnover

9. Business Turnover10. Business Cycle11. Current Assets requirements12. Production Cycle



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13. Credit control14. Inflation or Price level changes15. Profit planning and control

16. Repayment ability17. Cash reserves18. Operation efficiency19. Change in Technology20. Firms finance and dividend policy

21. Attitude towards Risk



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EXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have adequateworking capital to run its businessoperations. It should have neither redundant

or excess working capital nor inadequate orshortage of working capital.

Both excess as well as shortage of working

capital situations are bad for any business.However, out of the two, inadequacy orshortage of working capital is moredangerous from the point of view of the firm.



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Disadvantages of Excess Working Capital1. Idle funds, non-profitable for business,poor ROI2. Unnecessary purchasing & accumulation

of inventories over required level3. Excessive debtors and defective creditpolicy, higher incidence of B/D.4. Overall inefficiency in the organization.

5. When there is excessive working capital,Credit worthiness suffers6. Due to low rate of return on investments,the market value of shares may fall



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Disadvantages of Inadequate WorkingCapital1. Cant pay off its short-term liabilities intime.

2. Economies of scale are not possible.3. Difficult for the firm to exploitfavourable market situations4. Day-to-day liquidity worsens

5. Improper utilization the fixed assetsand ROA/ROI falls sharply



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Working Capital Management

Decisions relating to working capital and shortterm financing are referred to as working capitalmanagement. Short term financial managementconcerned with decisions regarding to CA and CL.

Management of Working capital refers tomanagement 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 betweena firm's short-term assets and its short-termliabilities.


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The goal of working capital management is to ensurethat the firm is able to continue its operations andthat it has sufficient cash flow to satisfy bothmaturing short-term debt and upcoming operational

expenses.

Businesses face ever increasing pressure on costsand financing requirements as a result of intensifiedcompetition on globalised markets. When trying to

attain greater efficiency, it is important not to focusexclusively on income and expense items, but to alsotake into account the capital structure, whoseimprovement can free up valuable financial resources


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Active working capital management is an

extremely effective way to increaseenterprise value.

Optimising working capital results in a rapidrelease of liquid resources and contributes toan improvement in free cash flow and to apermanent reduction in inventory and capitalcosts, thereby increasing liquidity forstrategic investment and debt reduction

Process optimisation then helps increaseprofitability.



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The fundamental principles of working capital

management are reducing the capital

employed and improving efficiency in the

areas of receivables, inventories, and

payables.



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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.



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Concepts of Working Capital

Gross Working Capital Net working Capital



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Gross Working Capital

Total Current assets

Where Current assets are the assetsthat can be converted into cashwithin an accounting year & includecash , debtors etc.

Referred as Economics Conceptsince assets are employed to derivea rate of return.



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Net Working Capital

CA CL

Referred as point of view of anAccountant.

It indicates liquidity position of a firm& suggests the extent to whichworking capital needs may befinanced by permanent sources offunds.


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CONSTITUENTS OF WORKING CAPITAL

CURRENT ASSETS Inventory

Sundry Debtors

Cash and Bank Balances Loans and advances

CURRENT LIABILITIES

Sundry creditors Short term loans

Provisions


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Characteristics of Current Assets

Short Life Span

I.e. cash balances may be held idle for aweek or two , thus a/c may have a life span

of 30-60 days etc. Swift Transformation into other Asset forms

I.e.each CA is swiftly transformed into otherasset forms like cash is used for acquiring raw

materials , raw materials are transformed intofinished goods and these sold on credit areconvertible into A/R & finlly into cash.


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Matching Principle

If a firm finances a long term asset(likemachinery) with a S-T Debt then it willhave to be periodically finance the assetwhich will be risky as well as inconvenient.

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

Thus Fixed Assets & permanent CA shouldbe supported with L-T sources of finance &fluctuating CA by S-T sources.


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Need for Working Capital

As profits earned depend upon magnitude ofsales and they do not convert into cashinstantly, thus there is a need for workingcapital in the form of CA so as to deal with

the problem arising from lack of immediaterealisation of cash against goods sold.

This is referred to as Operating or CashCycle .

It is defined as The continuing flow fromcash to suppliers, to inventory , to accountsreceivable & back into cash .


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Need for Working Capital

Thus needs for working capital arises fromcash 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 cycleis the major determinant of the firmsworking capital needs.


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Operating or Cash Cycle

1. Conversion of cash into inventory

2. Conversion of inventory intoReceivables

3. Conversion of Receivables into Cash


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TYPES OF WORKING CAPITAL

permanent working capital

variable working capital


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PERMANENT WORKING CAPITAL

There is always a minimum level of cawhich is continuously required by a firm tocarry on its business operations.

Thus , the minimum level of investmentin current assets that is required tocontinue the business without interruption

is referred as permanent working capital.


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VARIABLE WORKING CAPITAL

This is the amount of investment required to takecare of fluctuations in business activity or neededto meet fluctuations in demand consequent uponchanges in production & sales as a result of

seasonalchanges.


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DISTINCTION

Permanent is stable over time whereas variable isfluctuating according to seasonal demands.

Investment in permanent portion can bepredicted with some profitability whereas

investment in variablecannot be predicted easily. While permanent is minimum investment in

various current assets , variable is expected totake care for peak in business activity.


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DISTINCTION

While permanent component reflects the need fora certain irreducible level of current assets on acontinous and uninterrupted basis , thetemporary portion is needed to meet seasonal &

other temporary requirements. Also permanent capital requirements should be

financed from l-t sources , s-tfunds should beused to finance temporary working capital needs

of a firm,


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Monetary and Credit Policies

Monetary policy is the process by which the govt.,centralbank, or monetary authority of a country controls (i) thesupply of money, (ii) availability of money, and (iii) cost ofmoney 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, or monetary authority of a country controls (i)the supply of money, (ii) availability of money, and (iii) costof money or rate of interest, in order to attain a set ofobjectives oriented towards the growth and stability of the

economy. Monetary theory provides insight into how tocraft optimal monetary policy.

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


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Credit Policy

Credit gives the customer the opportunity to buy goods andservices, and pay for them 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(4) steps to be taken in case of customer delinquency . Alsocalled collection policy.

Where delinquency means Failure to repay an obligationwhen due or as agreed. Thus in consumer installmentloans, missing two successive payments will normally make

the account delinquent


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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.


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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.


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Instruments of Monetary Policy

Money Supply

Bank Rate

Reserve Ratios Interest Rates

Selective Credit Controls

Flow of Credit


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Money Supply

This is the sum total of money public funds andcan be used for settling transactions to buy andsell things and make other payments constitutesthe money supply of a nation.

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


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Bank Rate

Standard rate at which bank is prepared to buy orrediscount bills of exchange or other commercial paperseligible for purchase

The rate of interest charged by central bank on their loansto commercial banks is called bank rate(Discount rate).

An increase in bank rate makes it more expensive forcommercial banks to borrow . This exerts pressure to bringabout the rise in interest rates (lending rates) charged bycommercial banks on their lending to public. This leads to ageneral tightening in economy.

Whereas decrease in bank rate has the opposite effect andleads to general easing of credit in the economy.


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RESERVE REQUIREMENTS

The reserve requirement (or required reserveratio) is a bank regulation that sets the minimumreserves each bank must hold to customer deposits andnotes. These reserves are designed to satisfywithdrawal demands, and would normally be in the

form of fiat currency stored in a bank vault(vault cash),or with a central bank.

The reserve ratio is sometimes used as a tool in themonetary policy, influencing the country's economy,borrowing, and interest rates .Western central banksrarely alter the reserve requirements because it wouldcause immediate liquidity problems for banks with lowexcess reserves; they prefer to use open marketoperations to implement their monetary policy


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RESERVE REQUIREMENTS

Thus central bank makes it legallyobligatory for commercial banks tokeep a certain minimum percentage

of deposits in reserve.

These are of 2 types:-

1. Cash reserves

2. Liquidity reserves


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CASH RESERVE RATIO

CASH RESERVE RATIO

THIS IS DEFINED AS A cash reserveratio (or CRR) is the percentage ofbank reserves to deposits and notes.The cash reserve ratio is also knownas the cash asset ratio or liquidity

ratio.


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STATUTORY LIQUIDITY RATIO

Statutory Liquidity Ratio (SLR) It is the amount

which a bank has to maintain in the form:

Cash

Gold valued at a price not exceeding the currentmarket price,

Unencumbered approved securities (G Secs or Gilts

come under this) valued at a price from time to

time.


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STATUTORY LIQUIDITY RATIO

The quantum is specified as some percentage ofthe total demand and time liabilities ( i.e. theliabilities of the bank which are payable ondemand anytime, and those liabilities which areaccruing in one months time due to maturity) ofa bank. This percentage is fixed by the Bank of

Ghana

The objectives of SLR are: 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 support the credit growthin Ghana.


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INTEREST RATES

This is generally done by stipulating min. rates ofinterest for extending credit against commoditiesunder selective credit control.

Also, concessive or ceiling rates of interest are

made applicable to advances for certain purposesalso to certain sectors to reduce the interestburden and thus facilitate their development.

Further obj. behind fixing rates on deposits are toavoid unhealthy competition amongst the banks

for deposits and keep the level of deposit rates inalignment with lending rates of banks fordeposits.


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These are Qualitative instrumentswhich are aimed at affectingchanges in the availability of credit

with respect to particular sectors ofthe economy.

Thus selective controls are calledselective because they are aimed atmovement of credit towardsselective sectors of the economy.


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

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

Quantitative instruments are calledquantitative because they affect the totalvolume(quantity) of money supply andcredit in the country.


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The most widely used qualitativetechniques are selective control and moralsuasion.

While the general credit controls operate

on the cost and total volume of credit ,selective credit controls relate to toolsavailable with the monetary authority forregulating the distribution or direction ofbank resources to particular sectors of

economy in accordance with broadnational priorities considered necessaryfor achieving the set.


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MORAL SUASION

It implies the central bank exertingpressure on banks by using oral andwritten appeals to expand or restrict

credit in line with its credit policy.


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Different approaches indetermination of working capital

Industry norm approach

Economic modeling approach

Strategic choice approach


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INDUSTRY NORM APPROACH

This approach is based on thepremise that every company isguided by the industry practice.

Like if majority of firms have beengranting 3 months credit to acustomer then others will have toalso follow the majority due to fear

of losing customers.


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ECONOMIC MODELLING APPROACH

To estimate optimum inventory isdecided with the help of eoq model.


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STRATEGIC CHOICE APPROACH

This approach recognises thevariations in business practice andadvocates use of strategy in taking

working capital decisions. The purpose behind this approach is

to prepare the unit to face challengesof competition & take a strategic

position in the market place.


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STRATEGIC CHOICE APPROACH

The emphasis is on strategicbehavior of business unit. Thus thefirm is independent in choosing its

own course of action which is notguided by the rules of industry,


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Determinants of working capital

General nature of business

Production cycle

Business cycle

Credit policy

Production policy

Growth and expansion

Profit level

Operating efficiency

FORECASTING / ESTIMATION OF


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FORECASTING / ESTIMATION OFWORKING CAPITAL REQUIREMENTS

Factors to be considered

Total costs incurred on materials, wages and overheads

The length of time for which raw materials remain instores before they are issued to production.

The length of the production cycle or WIP, i.e., the time

taken for conversion of RM into FG. The length of the Sales Cycle during which FG are to be

kept waiting for sales.

The average period ofcredit allowed to customers.

The amount of cash required to pay day-to-day expenses

of the business. The amount of cash required for advance payments if

any.

The average period ofcredit to be allowed by suppliers.

Time lag in the payment of wages and other overheads

POINTS TO BE REMEMBERED WHILE


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POINTS TO BE REMEMBERED WHILEESTIMATING WC

(1) Profits should be ignored while calculating workingcapital requirements for the following reasons.

(a) Profits may or may not be used as working capital

(b) Even if it is used, it may be reduced by the amount ofIncome tax, Drawings, Dividend paid etc.

(2) Calculation of WIP depends on the degree ofcompletion as regards to materials, labour and overheads.However, if nothing is mentioned in the problem, take100% of the value as WIP. Because in such a case, theaverage period of WIP must have been calculated as

equivalent period of completed units. (3) Calculation of Stocks of Finished Goods and Debtors

should be made at cost unless otherwise asked in thequestion.


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Time & Money Concepts in Working CapitalCycle

Each component of working capital

(namely inventory, receivables andpayables) has two dimensions........TIME ......... and MONEY, when itcomes to managing working capital


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TIME IS MONEY

You can get money to move faster around the cycle or reduce the amount of money tied up. Then,business will generate more cash or it will need to borrow less money to fund working capital.

As a consequence, you could reduce the cost of bank interest or you'll have additional free money

available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increasedcredit limit, you effectively createfree finance to help fund future sales.

If you Then


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If you Then ......

Collect receivables (debtors)

faster

You release cash from the

cycleCollect receivables (debtors)

slowerYour receivables soak up

cash

Get better credit (in terms

of duration or amount) fromsuppliers

You increase your cash

resources

Shift inventory (stocks)

fasterYou free up cash

Move inventory (stocks)slower

You consume more cash

MANAGEMENT OF CASH


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MANAGEMENT OF CASH

1. Importance of CashWhen planning the short or long-termfunding requirements of a business, itis more important to forecast the likely

cash requirements than to projectprofitability etc.

Bear in mind that more businessesfail for lack of cash than for wantof profit.

Cash

vs

Profit


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Cash vs ProfitSales and costs and, therefore, profits

do not necessarily coincide with theirassociated cash inflows and outflows.

The net result is that cash receipts often

lag cash payments and, whilst profits maybe reported, the business may experiencea short-term cash shortfall.

For this reason it is essential toforecast cash flows as well as projectlikely profits.

Methods of ACCELERATING CASH INFLOWS


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Methods of ACCELERATING CASH INFLOWS Prompt payment from customers (Debtors)

Quick conversion of payment into cash

Decentralized collections

Lock Box System (collecting centers at differentlocations)

Methods of DECELERATING CASH OUTFLOWS

Paying on the last date Payment through Cheques and Drafts

Adjusting Payroll Funds (Reducing frequency ofpayments)

Centralization of Payments

Inter-bank transfers Making use of Float (Difference between balance in

Bank Pass Book and Bank Column of Cash Book)


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MANAGEMENT OF RECEVABLES

Receivables ( Sundry Debtors ) result fromCREDIT SALES.

A concern is required to allow credit in order toexpand its sales volume.

Receivables contribute a significant portion ofcurrent assets.

But for investment in receivables the firm has toincur certain costs (opportunity cost and time

value )Further, there is a risk of BAD DEBTS also.

It is, therefore very necessary to have a propercontrol and management of receivables.

AVERAGE COLLECTION PERIOD AND AGEING


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AVERAGE COLLECTION PERIOD AND AGEINGSCHEDULE

The collection of BOOK DEBTS can bemonitored with the use of averagecollection period and ageing

schedule.The ACTUAL AVERAGE COLLECTIONPERIOD IS COMPARED WITH THESTANDARD COLLECTION PERIOD toevaluate the efficiency of collection so

that necessary corrective action can beinitiated and taken.

Guidelines for Effective Receivables


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Guidelines for Effective ReceivablesManagement

1. Have the right mental attitude to the control

of credit and make sure that it gets thepriority it deserves.

2. Establish clear credit practices as a matter ofcompany policy.

3. Make sure that these practices are clearlyunderstood by staff, suppliers and customers.

4. Be professional when accepting newaccounts, and especially larger ones.

5. Check out each customer thoroughly before

you offer credit. Use credit agencies, bankreferences, industry sources etc.

6. Establish credit limits for each customer...and stick to them.

Guidelines for Effective Receivables


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7. Continuously review these limits whenyou suspect tough times are coming or ifoperating in a volatile sector.8. Keep very close to your largercustomers.

9. Invoice promptly and clearly.10. Consider charging penalties on overdueaccounts.11. Consider accepting credit /debit cardsas a payment option.

12. Monitor your debtor balances and ageingschedules, and don't let any debts get toolarge or too old.

Guidelines for Effective ReceivablesManagement

MANAGEMENT OF INVENTORIES


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MANAGEMENT OF INVENTORIES

Managing inventory is a juggling act.

Excessive stocks can place a heavy burdenon the cash resources of a business.

Insufficient stocks can result in lost sales,delays for customers etc.

INVENTORIES INCLUDERAW MATERIALS, WIP & FINISHEDGOODS


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FACTORS INFLUENCING INVENTORY MANAGEMENT

Lead Time Cost of Holding Inventory

Material Costs

Ordering CostsCarrying Costs

Cost of tying-up of Funds

Cost of Under stocking

Cost of Overstocking


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Stock Levels

Reorder Level

Maximum Level

Minimum LevelSafety Level / Danger Level

Variety Reduction

Materials Planning

Service Levels Obsolete Inventory and Scrap

Quantity Discounts

FACTORS INFLUENCING INVENTORY MANAGEMENT

INVENTORY MANAGEMENT TECHNIQUES


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INVENTORY MANAGEMENT TECHNIQUES

MANAGING INVENTORIES EFFICIENTLYDEPENDS ON TWO QUESTIONS

1. How much should be ordered?

2. When it should be ordered?

The first question how much toorderrelates to ECONOMIC ORDERQUANTITY and

The second question when toorderarises because of uncertaintyand relates to determining the RE-ORDER POINT

ECONOMIC ORDER QUANTITY [


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ECONOMIC ORDER QUANTITY [EOQ ]

The ordering quantity problems are solved by the firm bydetermining the EOQ ( or the Economic Lot Size ) that isthe optimum level of inventory.

There are two types of costs involved in this model.

ordering costs

carrying costs

The EOQ is that level of inventory which MINIMIZES the

total of ordering and carrying costs.


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ORDERING COSTS CARRYING COSTS

Requisitioning Warehousing

Order Placing Handling

Transportation Clerical Staff

Receiving,Inspecting & Storing

Insurance

Clerical & Staff Deterioration &Obsolescence

O O O G


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AN EYE-OPENER TO INVENTORY MANAGEMENT

For better stock/inventory control, try the

following: Review the effectiveness of existing purchasing

and inventory systems. Know the stock turn for all major items of

inventory. Apply tight controls to the significant fewitems

and simplify controls for the trivial many. Sell off outdated or slow moving merchandise - it

gets more difficult to sell the longer you keep it. Consider having part of your product outsourced

to another manufacturer rather than make ityourself.

Review your security procedures to ensure thatno stock "is going out the back door !"

MANAGEMENT OF ACCOUNTS PAYABLE


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Creditors are a vital part of effective cashmanagement and should be managedcarefully to enhance the cash position.Purchasing initiates cash outflows and anover-zealous purchasing function can

create liquidity problems.

Guidelines for effective management ofAccounts Payable



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Who authorizes purchasing in your company - is it tightly

managed or spread among a number of (junior) people?Are purchase quantities geared to demand forecasts?

Do you use order quantities which take account of stock-holding and purchasing costs?

Do you know the cost to the company of carrying stock ?

Do you have alternative sources of supply ? If not, getquotes from major suppliers and shop around for the bestdiscounts, credit terms, and reduce dependence on asingle supplier.

How many of your suppliers have a returns policy ?

Are you in a position to pass on cost increases quicklythrough price increases to your customers ?

If a supplier of goods or services lets you down can youcharge back the cost of the delay ?

Can you arrange (with confidence !) to have delivery of


Working Capital Management (BCM)

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