Working Capital Management-class

8/7/2019 Working Capital Management-class

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Working capital management

Decisions relating to working capital and short term financing are referred to

as working capital 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 to ensure that the firm is able to continue its operations and that it

has sufficient cash flow to satisfy both maturing short-term debt and upcoming

operational expenses.The management of working capital involves managing

inventories, accounts receivable and payable, and cash. Working capital

management is a significant concept in financial management due to the fact that it

plays a pivotal role in keeping the wheels of the business enterprise running.

Implementing an effective working capital management system is an excellent way

for many companies to improve their earnings.

Concept of working capital:

Hoagland defines working capital as follows:

Working capital is descriptive of that capital which is not fixed. But, the more

common use of working capital is to consider it as the difference between the book

value of the current assets and the current liabilities.

Working capital, also known as net working capital or NWC, circulating capital

and revolving capital is a financial metric which represents operating

liquidity available to a business. Its magnitude & composition keeps on changing

continuously in the course of business. Along with fixed assets such as plant and

equipment, working capital is considered a part of operating capital. It is calculated

as current assets minus current liabilities. If current assets are less than current

liabilities, an entity has a working capital deficiency, also called a working

capital deficit.

Working Capital = Current Assets Current Liabilities

Positive working capital means that the company is able to pay off its short-term

liabilities. Negative working capital means that a company currently is unable

to meet its short-term liabilities with its current assets


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A company can be endowed with assets and profitability but short of liquidity if its

assets cannot readily be converted into cash. Positive working capital is required to

ensure that a firm is able to continue its operations and that it has sufficient funds

to satisfy both maturing short-term debt and upcoming operational expenses. The

management of working capital involves managing inventories, accountsreceivable and payable and cash.

If a company's current assets do not exceed its current liabilities, then it may run

into trouble paying back creditors in the short term. The worst-case scenario is

bankruptcy. A declining working capital ratio over a longer time period could also

be a red flag that warrants further analysis. For example, it could be that the

company's sales volumes are decreasing and, as a result, its accounts receivables

number continues to get smaller and smaller.

Working capital also gives investors an idea of the company's underlying

operational efficiency. Money that is tied up in inventory or money that customers

still owe to the company cannot be used to pay off any of the

company's obligations. So, if a company is not operating in the most efficient

manner (slow collection), it will show up as an increase in the working capital.

This can be seen by comparing the working capital from one period to

another; slow collection may signal an underlying problem in the company'soperations.

CLASSIFICATION OF WORKING CAPITAL

Working capital can be classified as follows:

On the basis of time

On the basis of concept


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Determining the Amount of Working Capital

Working capitalis the result of subtracting current liabilities from current assets.It is a measure of a company's solvency, its capacity to make large purchases and

take advantage of bulk discounts, and its ability to attract customers by offering

advantageous credit terms.

Components of working capital:

Working capital comprises of 2 major components;

a) Current assets

b) Current liabilities


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Current assets and current liabilities are..........

In accounting, a current asset is an asset on the balance sheet which is expected to

be sold or otherwise used up in the near future, usually within one year, or

one business cycle - whichever is longer.

Current assets include cash, cash equivalents, accounts receivable, inventory

including raw materials; work in progress; finished stock, the portion of prepaid

accounts which will be used within a year, short term advances, short-term

investments, sundry debtors, accrued incomes, and marketable securities.

On the balance sheet, assets will typically be classified into current assets

and long-term assets.

Current Assets = Cash + Bank + Debtors + Bills Receivable + Short Term

Investment + Inventory + Prepaid Expenses

Current liabilities are the debts a company owes which must be paid within one

year. They are the opposite of current assets.

Current liabilities includes things such as short term loans, accounts payable,

dividends and interest payable, bonds payable, consumer deposits, reserves for

Federal taxes, bank overdraft, and other liabilities maturing within one period.

Current liabilities = creditors + accounts payable + short term borrowings +

accrued expenses +dividend & taxes payable +bank overdraft.

The current ratio is calculated by dividing total current assets by total current

liabilities. It is frequently used as an indicator of a company's liquidity, its ability

to meet short-term obligations.


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Why should the managers of a business pay special attention to

working capital??????Management must ensure that a business has sufficient working capital. Too little

will result in cash flow problems highlighted by an organization exceeding its

agreed overdraft limit, failing to pay suppliers on time and being unable to claimdiscounts for prompt payment. In the long run, a business with insufficient

working capital will be unable to meet its current obligations and will be forced to

cease trading even if it remains profitable on paper.

On the other hand, if an organization ties up too much of its resources in working

capital it will earn a lower than expected rate of return on capital employed. Again

this is not a desirable situation.

The other problems associated with inadequate & excessive working

capital are:WORKING CAPITAL SHOULD BE ADEQUATE NEITHER

EXCESSIVE NOR INADEQUATE!!!!!!!!!!!!!!

Advantages Of Adequate Working Capital:

Solvency Of the Business

Goodwill

Easy loans

Cash discounts

Regular supply of raw materials

Regular Payments To Employees

Favourable Policy Decisions As Per Market Trends

Quick And Regular Return On Investment

Disadvantages Of Inadequate Working Capital:

Difficulty In Meeting Operational Expenses

Loss Of Favourable Business Opportunity


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Loss Of Goodwill

Reduction in overall efficiency of the business

Cant pay off its short-term liabilities in time.

Economies of scale are not possible.

Difficult for the firm to exploit favourable market situations

Day-to-day liquidity worsens

Improper utilization the fixed assets and ROA/ROI falls sharply

Disadvantages of Excessive Working Capital:

Blockage Of Funds

Excessive Purchasing

Excessive Debtors

Idle funds, non-profitable for business, poor ROI

Unnecessary purchasing & accumulation of inventories over required level

Excessive debtors and defective credit policy, higher incidence of B/D

Overall inefficiency in the organization.

When there is excessive working capital, Credit worthiness suffers

Due to low rate of return on investments, the market value of shares may fall

Factors affecting working capital requirement:

There is no set of universally applicable rules to ascertain working capital needs of

a business organization. A host of factors influencing of working capital needs of a

firm can be categorized into two categories viz., internal factors and external

factors.


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INTERNAL FACTORS:

Nature of Business

Size of Business

Firms production Policy

Firms credit Policy

Access to Money Market

Growth and Expansion of Business

Profit Margin and Dividend Policy

Depreciation Policy

Working capital cycle

Operating Efficiency of Firm.

EXTERNAL FACTORS :

Business Fluctuations.

Technological Development

Transport and Communication Development

Import Policy

Taxation Policy

MANAGEMENT OF WORKING CAPITAL

Management of working capital is concerned with the problem that arises in

attempting to manage the current assets, current liabilities. The basic goal of

working capital management is to manage the current assets and current liabilities

of a firm in such a way that a satisfactory level of working capital is maintained,


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i.e. it is neither adequate nor excessive as both the situations are bad for any firm.

There should be no shortage of funds and also no working capital should be ideal.

WORKING CAPITAL MANAGEMENT POLICES of a firm has a great on its

probability, liquidity and structural health of the organization. So working capital

management is three dimensional in nature as

1. It concerned with the formulation of policies with regard to

profitability, liquidity and risk.

2. It is concerned with the decision about the composition and level of

current assets.

3. It is concerned with the decision about the composition and level of

current liabilities.


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TANDON COMMITTEE-

Lending Norms:

Ist Recommendation

The borrower has to contribute a minimum 25% of working capital gap from long

term funds.

IInd Recommendation

The borrower has to contribute a minimum of 25% of the total current assets from

long term funds.


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IIIrd Recommendation

The borrower has to contribute the entire core current assets and a minimum of

25% of the balance of the current assets from long term funds.

Maximum Permissable Bank Finance (MPBF):

Calculation of maximum permissible bank finance (MPBF)

Method 1 (Low Risk Category of Borrowers) 0.75(CA-CL)

Method 2 (Medium Risk category of borrowers) 0.75CA-CL

Method 3 (High Risk Category of borrowers) 0.75(CA-CCA)-CL

Where;

CA = Current assets

CL = Currents Liabilities excluding bank overdraft or any Short Term

Bank Borrowings

CCA = Core Current Assets

Practical problems:

1) A proforma cost sheet of raju brothers privatelimited provides the following particulars.

Elements of cost Amount per unit

Raw material

Direct labour

Overheads

Total cost

Profit

Selling price

80

30

60

170

30

200


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The following further particulars are available:

a) Raw materials are in stock for one month

b) Credit allowed by suppliers is one month

c) Credit allowed to customers is two months

d) Lag in payment of wages 1.5 weeks

e) Lag in payment of overheads one month

f) Materials are in process for an average of half month

g) Finished goods are in stock for an average of one month

h) 1/4th of output is sold against cash

Cash in hand and at bank is expected to be Rs. 25000. You are

requested to prepare a statement showing the working capital

needed to finance a level of activity of 104000units of product.

You may assume that production is carried on evenly throughout the

year. Wages and overheads accrue similarly and a period of 4 weeks

is equivalent to a month.

(2) Calculate the working capital of royal industries from thefollowing particular:

a) Annual expenses:

Wages Rs. 52000

Stores and materials Rs. 9600

Office salaries Rs. 12480

Rent Rs. 2000

Other expenses Rs. 9600

b) Average amount of stocks to be maintained

Finished goods stock Rs. 1000

Material/stores stock Rs. 1600


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c) Expenses paid in advance

(Quarterly advance) Rs. 1600 p.a.

d) Annual sales

Home market Rs. 62400

Foreign market Rs. 15600

e) Lag in payment of

Wages 1.5 weeks

Stores and material 1.5 months

Office salaries 0.5 months

Rent 6 months

Other expenses 1.5 months

f) Credit allowed to customers

Home market 6 months

Foreign market 1.5 months

Concept of operating cycle

Proper and Effective working capital forecasting and control on working capital

will lead to efficient working capital management. The effectiveness in the above

twin can be achieved if the complete information about the operating cycle is

known.


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The working capital cycle can be defined as:

The period of time which elapses between the point at which cash begins to

be expended on the production of a product and the collection of cash from a

customer.

The working capital cycle measures the amount of time that elapses between the

moment when your business begins investing money in a product or service, and

the moment the business receives payment for

that product or service. This doesnt necessarily begin when you manufacture a

productbusinesses often invest money in products when they hire people to

produce goods, or when they buy raw materials.

It is important to measure working capital because..

A good working capital cycle balances incoming and outgoing payments tomaximize working capital. Simply put, you need to know you can afford to

research, produce, and sell your product.

A short working capital cycle suggests a business has good cash flow. For

example, a company that pays contractors in 7 days but takes 30 days to collect

payments has 23 days of working capital to fundalso

known as having a working capital cycle of 23 days. Amazon.com, in contrast,

collects money before it pays for goods. This means the company has a negative

working capital cycle and has more capital available

to fund growth. For a business to grow, it needs access to cashand being able tofree up cash from the working capital cycle is cheaper than other sources of

finance, such as loans.

How It Works in Practice???????

The key to understanding a companys working capital cycle is to know where

payments are collected and made, and to identify areas where the cycle is stretched

and can potentially be reduced.

The working capital cycle is a diagram rather than a mathematical calculation. The

cycle shows all the cash coming in to the business, what it is used for, and how itleaves the business (i.e., what it is spent on).

A simple working capital cycle diagram is shown in Figure 1. The arrows in the

diagram show the movement of assets through the businessincluding cash, but

also other assets such as raw materials and finished


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goods. Each item represents a reservoir of assetsfor example, cash into the

business is converted into labor. The working capital cycle will break down if there

is not a supply of assets moving continually through

the cycle (known as a liquidity crisis).

Figure 1. A simple working capital cycle diagram

The working capital diagram should be customized to show the way capital moves

around your business.

More complex diagrams might include incoming assets such as cash payments,

interest payments, loans, and equity. Items that commonly absorb cash would belabor, inventory, and suppliers.

The key thing to model is the time lag between each item on the diagram. For some

businesses, there may be a very long delay between making the product and

receiving cash from sales. Others may need to purchase raw materials a long time

before the product can be manufactured. Once you have this information, it is

possible to calculate your total working capital cycle, and potentially identify

where time lags within the cycle can be reduced or eliminated.

Operating Cycle:

Time duration required from procurement of raw material and ending with sales

realization.


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Chronological sequence in which working capital cycle operates:

1. Procurement of raw material.

2. Conversion of raw material to WIP

3. Conversion of WIP to Finished goods

4. Sale of Finished Goods (Cash or Credit)

5. Conversion of receivables into cash

Operating Cycle Period:

1. Inventory conversion Period: It is the time required for conversion of raw

material to finished goods.

Inventory conversion period


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Avg. inventory

= _________________

Cost of sales/365

2. Receivables Conversion Period: It is the time required to convert the credit

sales to sales realization.

Receivable conversion period

Accounts receivable

= ___________________

Annual credit sales/365

1. Payables deferral period

Accounts payable + Salaries, etc

= ___________________________

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

Net operating Cycle= Inventory conversion period+ Receivables conversion

period deferral period (Credit period allowed by suppliers)

Cash conversion cycle = operating cycle payables deferral period.

The diagram below illustrates the working capital cycle for a manufacturingfirm


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The upper

portion of thediagram above

shows in a

simplified

form the chain

of events in a

manufacturing

firm. Each of

the boxes in

the upper part

of the diagramcan be seen as

a tank through

which funds

flow. These tanks, which are concerned with day-to-day activities, have funds

constantly flowing into and out of them.

The chain starts with the firm buying raw materials on credit.

In due course this stock will be used in production, work will be carried out on

the stock, and it will become part of the firms work in progress (WIP)

Work will continue on the WIP until it eventually emerges as the finished product

As production progresses, labour costs and overheads will need to be met

Of course at some stage trade creditors will need to be paid

When the finished goods are sold on credit, debtors are increased

They will eventually pay, so that cash will be injected into the firm

Each of the areas stocks (raw materials, work in progress and finished goods),

trade debtors, cash (positive or negative) and trade creditors can be viewed as

tanks into and from which funds flow.


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Working capital is clearly not the only aspect of a business that affects the amount

of cash:

The business will have to make payments to government for taxation

Fixed assets will be purchased and sold

Lessors of fixed assets will be paid their rent

Shareholders (existing or new) may provide new funds in the form of cash

Some shares may be redeemed for cash

Dividends may be paid

Long-term loan creditors (existing or new) may provide loan finance, loans willneed to be repaid from time to time, and

Interest obligations will have to be met by the business.

Unlike movements in the working capital items, most of these non-working

capital cash transactions are not every day events. Some of them are annual events

(e.g. tax payments, lease payments, dividends, interest and, possibly, fixed asset

purchases and sales). Others (e.g. new equity and loan finance and redemption of

old equity and loan finance) would typically be rarer events.

Importance & use of working capital

Working capital management is very essential as most of the

business falls due to lack of cash than of profits. It is the

business's life blood and every manager's primary task is to help

keep it flowing and to use the cash flow to generate profits. The

faster a business expands, the more cash it will need for working

capital and investment. Good management of working capital

will generate cash, will help improve profits and reduce risks.

For investors, the working capital cycle is most relevant when

analyzing capital-intensive businesses where cash flow is used

to buy inventory. Typically, the working capital cycle of

retailers, consumer goods, and consumer goods manufacturers is

critical to their success.


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The working capital cycle should be considered alongside the

cash conversion cyclea measure of working capital efficiency

that gives clues about the average number of days that working

capital is invested in the operating cycle.

There are two elements in the business cycle that absorb cash

- Inventory (stocks and work-in-progress)

and Receivables (debtors owing you money). The main sources

of cash are Payables (your creditors) and Equity and Loans.

Time & Money Concepts in Working Capital Cycle

Each component of working capital (namely inventory,

receivables and payables) has two dimensions ........TIME .........

and MONEY. When it comes to managing working capital

- TIME IS MONEY. If you can get money to move faster

around the cycle (e.g. collect monies due from debtors more

quickly) or reduce the amount of money tied up (e.g. reduceinventory levels relative to sales), the 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


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an increased credit limit, you effectively create free finance to

help fund future sales.

If you ....... Then ......

Collect receivables

(debtors) faster

You release cash from the cycle

Collect receivables

(debtors) slower

Your receivables soak up cash

Get better credit (in

terms of duration or

amount) from

suppliers

You increase your cash resources

Shift inventory

(stocks) faster

You free up cash

Move inventory

(stocks) slower

You consume more cash

Sources of Additional Working Capital

Sources of additional working capital include the following:

Existing cash reserves Profits (when you secure it as cash !) Payables (credit from suppliers) New equity or loans from shareholders Bank overdrafts or lines of credit Long-term loan.


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(I)From the following information of X & Co , compute the

operating cycle in days and working capital requirements:

Period covered

Average period of credit showed by suppliers

365 days

6 days

Amount

(Rs.000)Average Total Debtors Outstanding

Raw material consumption

Total Production cost

Total cost of sales

Sales for the year (credit)

Value for average stock maintained:

Raw material

W-I-P

Finished goods

420

5840

10220

10950

12775

480

420

660

(II) Given below are the summarized income statements of

infinity limited for the year ended 31st march 2007 and theprojected year 31st march 2008:

31-3-2007

(Rs.Lakhs)

31-3-2008

(Rs.lakhs)


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Sales

Less: Consumption of raw materials

Depreciation

Other manufacturing expenses

Adjustment of opening & closing stock

Cost of goods sold

Gross profit

Less: Interest

General selling expenses

Profit before tax

600

180

12

174

(6)

360

240

30

150

60

720

240

15

186

(9)

432

288

40

200

48

The companys average inventory, debtors & creditors levels for

the year 2006-2007 were as follows:

Rs. In lakhs

Raw materials

Semi finished goods

Finished goods

Debtors

15

15

30

100


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Working Capital Management-class

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