Chapter Working Capital Management

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Chapter 26

WORKING CAPITAL MANAGEMENT


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OUTLINE

Introduction

Constituents of current assets & current liabilities

Characteristics of Current Assets

Factors Influencing Working Capital Requirements

Level of Current Assets

Current Assets Financing Policy

Profit Criterion for Current Assets

Operating Cycle Analysis

Cash Requirement for Working Capital


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INTRODUCTION

This chapter introduces working capital management or short term

financial management which is concerned with decisions relating tocurrent assets & current liabilities

The key difference between LTFM & WCM is in terms of the timing

of cash

Two concepts of working capital:

a. Gross working capital: Total of all current assets

b. Net working capital: Current assets Current Liabilities

Importance of Working Capital:

a. Investment in current assets represents a substantial portion of total

investment

b. Investment in current assets & the level of current liabilities have to

be geared quickly to changes in sales


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CONSTITUENTS OF

CURRENT ASSETS & CURRENT LIABILITIES

Current Assets:

Inventories

- Raw material

- Work in Process- Finished Goods

- Others

Trade Debtors

Loans & Advances

Cash & Bank Balance

Current Liabilities:

Sundry Creditors

Trade Advances

Borrowings [Short Term]- Commercial Banks

- Others

Provisions


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CHARACTERISTICS OF CURRENT ASSETS

Short life span

Swift transformation into other asset forms

Current Assets Cycle

Accounts

receivable

Finished

goods

Wages, salaries,

factory overheads

Work-in-

process

Raw

materials

Cash Suppliers


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Implications of Current Assets:

1. Decisions relating to working capital management are repetitiveand frequent

2. The difference between profit and present value is insignificant

3. Efficient management of one component cannot be undertaken

without simultaneous consideration of other components


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FACTORS INFLUENCING

WORKING CAPITAL REQUIREMENTS

Nature of Business

-Service Firm: Modest WC requirement

-Manufacturing Firm: Substantial WC requirement Seasonality of Operations

Production Policy

Market Conditions

Conditions of Supply


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WORKING CAPITAL POLICY

Two important issues in working capital policy are:

What should be the level of investment in current

assets?

What mix of long-term and short-term financing should

the firm employ to support current assets?


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LEVEL OF CURRENT ASSETS

Flexible Restrictive

(Conservative) (Aggressive)Policy Policy

Liquidity High Low

Inventories Large Small

Debtors High Low

A flexible policy results in fewer production stoppages, ensures

quicker deliveries to customers, and stimulates sales .. but

HIGHER INVESTMENT IN CURRENT ASSETS

A restrictive policy leads to more production stoppages, delayed

deliveries to customers, and lost sales but

LOWER INVESTMENT IN CURRENT ASSETS

- Refer Exhibit 26.4 on Page 695


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CAPITAL REQUIREMENTS

AND THEIR FINANCING

Capital

requirements

Fluctuating currentasset requirement

Permanent current

asset-requirement

Fixed asset

requirement

Time

A

B

C

- Refer Page 696


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CURRENT ASSETS FINANCING

POLICY

According to the matching principle, fixed assets and

permanent current assets should be supported by long-

term sources of finance whereas fluctuating current assets

must be supported by short-term sources of finance.


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PROFIT CRITERION FOR

WORKING CAPITAL

Investment in current assets is easily reversible.

For reversible investments, the criterion of net profit per

period (which here means residual income) is equivalent

to the criterion of net present value


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OPERATING CYCLE AND CASH CYCLE

The investment in working capital is influenced by four key events in the

production and sales cycle of the firm:

-Purchase of raw materials

-Payment of raw materials

-Sale of finished goods-Collection of cash for sales


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OPERATING CYCLE AND CASH CYCLE

Order placed Stock arrives Goods sold Cash received

Inventory period Accounts

receivable period

Accounts

payable period

Firm receives Cash paid for

invoice materials

Operating cycle

Cash cycle

Average inventory

Inventory period =

Average COGS / 365

Average accounts receivable

Accounts receivable period =

Annual sales / 365

Average accounts payable

Average payable period =

Average COGS / 365

-The operating cycle= Inventory period + Accounts receivable period-The cash cycle= Operating cycle - Accounts payable period


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ILLUSTRATION

Financial Information for Horizon Limited

Balance Sheet Data

Profit and Loss Beginning of End of

Account Data 20X0 20X0

Sales 800 Inventory 96 102

Cost of goods 720 Accounts receivable 86 90

Sold Accounts payable 56 60

(96 + 102) / 2Inventory period = = 50.1 days

720 / 365


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(86 + 90) / 2

Accounts receivable period = = 40.2 days

800 / 365

(56 + 60) / 2

Accounts payable period = = 29.4 days

720 / 365

Operating cycle = 50.1 + 40.2 = 90.3 daysInventory Accounts

period receivable

period

Cash cycle = 90.3 - 29.4 = 60.9 days

Operating Accounts

cycle payable period


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CASH REQUIREMENT FOR

WORKING CAPITAL

Step 1 : Estimate the cash cost of various current assets

required by the firm.

Step 2 : Deduct the spontaneous current liabilities from

the cash cost of current assets

- Refer Page 701


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SUMMING UP

Current assets have a short life span and are swiftly

transformed into other asset forms.

The working capital needs of a firm are influenced by

numerous factors : nature of business, seasonality of

operations, production policy, market conditions, andsupply conditions.

Determining the optimal level of current assets involves

a tradeoff between carrying costs and shortage costs.

According to the matching principle, the maturity of the

sources of finance should match the maturity of assets

being financed.


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The operating cycle of a firm begins with the acquisition

of raw materials and ends with the collection of

receivables.

The cash requirement of working capital is calculated by

estimating the cash cost of various current assets

required by the firm and deducting the spontaneous

current liabilities from the cash cost of current assets.


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PRACTICE TIME!!!

- Refer to the SOLVED PROBLEMS given at the end of the chapter- Solve all UNSOLVED PROBLEMS

Chapter Working Capital Management

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