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Transcript of CF__WCM_10
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Corporate Finance
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Topics Covered
Overview and Characteristics of Current Assets
Factors influencing Working Capital Requirements
Current Asset Policy
Current Assets Financing Policy
Profit Criterion for Current Assets
Operating Cycle Analysis
Duration of the Operating CycleWorking Capital Management_10
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Working CapitalThere are two concepts of working capital:
Gross Working CapitalNet Working Capital
Gross WC = Current Assets
Net WC = Current Assets Current Liabilities
Current Assets Current Liabilities
Working Capital Management_10
Inventories Sundry creditors
* Raw material Trade advances
* Work-in-progress Borrowings
* Finished goods * Commercial banksTrade debtors Provisions
Loans & advances
Cash & bank balance
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Characteristics of Working Capital
1) Management of working capital refers to themanagement of current assets as well as current
liabilities.
2) While management of working capital, the
c aracter st cs o current assets must e ta en
into consideration. These are:
i) Short life span, and
ii) Swift transformation into other asset forms
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--Working Capital3) The life span of current assets depends upon the
time required in the activities of procurement,production, sales, collection and the degree of
synchronisation among them.
Cash Raw Materials Work-in-process
a es n s e goo s
4) Efficient management of one component depends
upon the consideration of other components.
e.g.: i) If more finished goods inventory, more liberal creditterm is required.
ii) If the firm has a cash crunch, it may have to offer
generous discounts.Working Capital Management_10
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Factors affecting Working Capital Requirements
1) Nature of business
2) Seasonality of operations
3) Production policy
4) Market conditions
5) Conditions of supply
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Working Capital Policy
For formulating the Working Capital Policy, theimportant issues are as follows:
i) Ratio of Current Assets to Sales
ii Ratio of ST-financin to LT-Financin
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Current Assets in relation to Sales--
C
ur
Conservative
Sales
r
e
n
t
A
s
s
e
t
s
o era e
Aggressive
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--Current Assets in relation to Sales--
1) If the firm pursues a very conservative currentasset policy, it would carry a high level of current
assets in relation to sales.
It tends to reduce risk. The surplus current
assets under this policy enable the firm to cope-,
procurement time comfortably.
2) If the firm adopts a moderate current asset policy,it would carry a moderate level of current assets
in relation to sales.
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--Current Assets in relation to Sales--3) If the firm follows a highly aggressive current
asset policy, it would carry a low level of currentassets in relation to sales. It minimises the
investment in current assets which exposes the
firm to greater risk.
e.g.:
Working Capital Management_10
Sales Rs. 10,00,000 Rs. 10,00,000
EBIT Rs. 2,00,000 Rs. 2,00,000
Current Assets Rs. 6,00,000 Rs. 4,00,000
Fixed Assets Rs. 5,00,000 Rs. 5,00,000
Total Assets Rs. 11,00,000 Rs. 9,00,000
ROI (=EBIT/TA) 18.18% 22.22%
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Ratio of ST-Financing to LT-Financing
Current Assets of a firm are supported by short-termas well as long-term sources of Finance. Thus, we
have various types of Current Asset Financing Policy.
Conservative Current Asset Financing Policy
It de ends less on short-term financin and more on
Long-term sources of Finance.
If it is highly conservative, it would rather replace
long-term debt by equity.
Aggressive Current Asset Financing Policy
It depends highly on short-term bank finance and
less on the long-term sources of finance.
It exposes the firm to a higher degree of risk.Working Capital Management_10
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Choosing the Working Capital Policy
ModerateOverall WorkingCapital Policy
AggressiveOverall WorkingCapital Policy
Aggressi
ve
an
cing
Policy
ModerateOverall WorkingCapital Policy
ConservativeOverall WorkingCapital Policy
Conservative Aggressive
Current Asset Policy
conser
vativeC
urrent
AssetFi
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Note:
1) A Conservative Overall Working Capital Policy means that
the firm has a Conservative Current Asset Policy along witha Conservative Current Asset Financing Policy. It reduces
risk and offers low return.
2) A Moderate Overall Working Capital Policy means a
combination of Aggressive Current Asset Policy andConservative Current Asset Financing Policy OR,
Conservative Current Asset Policy along with Aggressive
Current Asset Financing Policy. It offers moderate return
and moderate risk.
3) An Aggressive Overall Working Capital Policy means that the
firm has an Aggressive Current Asset Policy along with
Aggressive Current Asset Financing Policy. It provides high
return accompanied with high risk.
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Profit Criterion for Working Capital--Current assets can be easily liquidated and the value realised
on liquidation would be more or less equal to the amountinvested initially.
i.e. investment in current assets is easily reversible.
For reversible investments, the criterion of net profit per
period (which here means residual income) is equivalent
to the criterion of net present value.,
interest earned on it and k the cost of capital.
Profit per year = Pr Pk
where,
Pr = return for the yearPk = cost of funds for the year
Let us assume that the investment in current assets continue
for n years.Working Capital Management_10
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--Profit Criterion for Working CapitalNow,
NPV = - P + Pr PVIFA(k,n) + P PVIF(k,n)Where,P = Initial investments in the current assets
Pr PVIFA(k,n) = PV of the annual return of Pr for a period of n
years
P PVIF(k,n) = PV of the liquidation value of P realised at the end of
n years,
NPV = (Pr Pk) PVIFA(k,n)
It is quite obvious from the above simplification that the
criterion of profit per period is equivalent to the criterion of netpresent value.
Hence, the criterion of net profit per period may be substituted
for the criterion of net present value in analysing working
capital decisions. Working Capital Management_10
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Operating Cycle AnalysisThe operating cycle of a firm begins with the
acquisition of raw materials and ends with thecollection of receivables.
It is divided into four stages:
ii) Work-in-Process Stage
iii) Finished Goods Inventory Stage
iv) Debtor Collection StageWorking Capital Management_10
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Duration of the Operating Cycle--It is equal to the sum of the durations of each of the
above stages less the credit period allowed by thesuppliers of the firm.
We have,
O = R + W + F + D C
Where,= ura on o e opera ng cyc e
R = Raw Materials and Stores Storage Period
W = Work-in-Process Period
F = Finished Goods Storage PeriodD = Debtor Collection Period
C = Creditors Payment Period
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Now,
R =
It depends upon the regularity of supply, transportation time,
degree of perishability, price fluctuations and economies of
bulk purchases.
W =
Average stock of raw materials and stores
Average raw materials and stores consumed per day
Average work-in-process inventory
It depends upon the length of manufacturing cycle,
consistency in capacities at different stages and efficient co-
ordination of various inputs.
Average cost of production per day
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F =
It depends upon the pattern of production and sales.
D =
It de ends u on the credit eriod discount offered for rom t
Average finished goods inventory
Average cost of goods sold
Average book-debts
Average credit sales per day
payments and efficiency of collection effort.
C =Average trade creditors
Average credit purchase per day
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Working Capital Management_10