Unit IVFinancial Management

• Management of Working Capital: Concepts of working Capital• Approaches to the financing of current

Assets• Determining capital (with numerical problems)• Management of different components

of working capital.Prepared by:-

Dr. Waqar Ahmad Asstt. Professor

Allenhouse Business School

WORKING CAPITAL• Working capital management involves the

relationship between a firm's short-term assets

and its short-term liabilities.

• The basic goal of working capital management

is to ensure that a firm is able to continue its

operations and that it has sufficient ability to

satisfy both maturing short-term debt and

upcoming operational expenses.

SINGNIFICANCE OF WORKING CAPITAL MANAGEMENT

In a typical manufacturing firm, current assets exceed one-half of

total assets.

Excessive levels can result in a substandard Return on Investment

(ROI).

Current liabilities are the principal source of external financing for

small firms.

Requires continuous, day-to-day managerial supervision.

Working capital management affects the company’s risk, return, and

share price.

WORKING CAPITAL CONCEPTS Net Working CapitalNet working capital refers to the difference between

current assets and current liabilities. Current liabilities are

those claims of outsider, which are expected to mature

For payment within an accounting year & include creditors,

bills payable & the outstanding expenses. In other words you

can say that this is the excess of current assets over current

liabilities.

Current Assets – Current Liabilities

WORKING CAPITAL CONCEPTSGross Working Capital•It refers to the firm’s investment in current assets.

•Current assets are the assets, which can be converted into

cash within an accounting year or within an operating cycle

•cash, short-term securities, debtors (accounts receivable &

book debts), bills receivable and stock.

Working capital turnover

Working capital turnover= sales/working capital

Working Capital Management

The administration of the firm’s current assets and the

financing needed to support current assets.

CURRENT ASSETS• Inventories: Inventories represent raw materials and components, work-in-progress and finished goods. Trade Debtors: Trade Debtors comprise credit sales to customers. Prepaid Expenses: These are those expenses, which have been paid for goods and services whose benefits have yet to be received. Loan and Advances: They represent loans and advances given by the firm to other firms for a short period of time. Investment: These assets comprise short-term surplus funds invested in government securities, shares and short-terms bonds. Cash and Bank Balance: These assets represent cash in hand and at bank, which are used for meeting operational requirements. One thing you can see here is that this current asset is purely liquid but non-productive.

CURRENT LIABILITYSundry Creditors: These liabilities stem out of purchase of raw materials on credit terms usually for a period of one to two months. Bank Overdrafts: These include withdrawals in excess of credit balance standing in the firm’s current accounts with banks Short-term Loans: Short-terms borrowings by the firm from banks and others form part of current liabilities as short-term loans. Provisions: These include provisions for taxation, proposed dividends and contingencies.

WORKING CAPITAL FORMATCURRENT ASSETS CURRENT LIABILITIES• Cash • Accounts receivable• Notes receivable• Marketable securities• Inventory• Prepaid expenses

Total current assets

• Accounts payable• Notes payable• Accrued expenses• Taxes payable

Total current liabilities

POINTS KEPT IN MIND WHILE PLANNING1. Excessive investment (Profitability) • It results in unnecessary accumulation of

inventories. Thus, chances of inventory mishandling, waste, theft & losses increase.

• It is an indication of defective credit policy & slack collection period. • Excessive WC makes management complacent,

which degenerates into managerial inefficiency. • Tendencies of accumulating inventories tend to

make speculative profits grow.

POINTS KEPT IN MIND WHILE PLANNIN CONT…2. Inadequate investment (Liquidity) It stagnates growth. It become difficult to implement operating plans and

achieve the firm’s operating profit target. Operating inefficiencies creep in when it becomes difficult

even to meet day-to-day commitments. Fixed assets are not efficiently utilized for the lack of

working capital funds. Thus, the firm’s profitability would deteriorate.

Paucity of WC funds render the firm unable to avail attractive credit opportunities.

The firm loses its reputation when it is not in a position to honour its short-term obligations.

KINDS OF WORKING CAPITAL

1.Permanent working capitalPermanent working capital is the minimum amount of

current assets, which is needed to conduct a business even during the dullest season of the year.

The minimum level of current assets is called permanent or fixed working capital as this part is permanently blocked in current assets.

Characteristics of Permanent working capital It is classified on the basis of the time period It constantly changes from one asset to another and

continues to remain in the business process. Its size increase with the growth of business operations.

Permanent working capital

Permanent working capital CONT…2.Temporary working capitalTemporary working capital represents a certain amount of

fluctuations in the total current assets during a short period.

Variable working capital is the amount of additional current asset that are required to meet the seasonal needs of a firm, so is also called as the seasonal working capital.

Characteristics of Temporary working capital It is not always gainfully employed, though it may change from one asset to another asset, as permanent working capital does.

It is particularly suited to business of a seasonal or cyclical nature.

TEMPORARY WORKING CAPITAL

DETERMINANTS OF WORKING CAPITAL• Nature of business• Terms of sales and purchases• Manufacturing cycle• Rapidity of turnover• Business cycle• Changes in technology• Seasonal variation• Market conditions• Seasonality of operation• Dividend policy• Working capital cycle

Importance of Working Capital:• It helps measure profitability of an enterprise. In its absence, there would be neither production nor profit.• Without adequate working capital an entity cannot meet its short-term liabilities in time.• A firm having a healthy working capital position can get loans easily from the market due to its high reputation or goodwill.• Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw materials and payment of wages.• Sound working capital helps maintain optimum level of investment in current assets.• It enhances liquidity, solvency, credit worthiness and reputation of enterprise.• It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise run successfully during periods of crisis.

Approaches of Working Capital

Approaches of Working Capital

1.Conservative Approach

2.Aggressive Approach

3.Matching Approach or Hedging

Approach

Conservative Approach1. Conservative approach is a risk-free strategy of

working capital financing. 2. A company adopting this strategy maintains a higher

level of current assets and therefore higher working capital also.

3. The major part of the working capital is financed by the long-term sources of funds such as equity, debentures, term loans etc. So, the risk associated with short-term financing is abolished to a great extent.

Conservative ApproachIn the conservative approach, fixed assets, permanent working capital and a part of temporary working capital is financed by long-term financing sources and the remaining part only is financed by short-term financing sources.

Financing Strategy in Equation:

Long Term Funds will Finance = Fixed Assets +

Permanent Working Capital + Part of Temporary

Working Capital

Short Term Funds will Finance = Remaining Part

of Temporary Working Capital

Conservative Approach Diagram

Conservative Approach DiagramThe dotted lines horizontal line indicates the point till which the long-term funds will be utilized. The dotted vertical lines indicate the sources of finance and they are tagged as ‘long-term financing’ and ‘short term financing’.

We can easily make out that long term funds are financing total fixed assets, total permanent assets and a part of the temporary or seasonal working capital also. Seasonal requirement or temporary working capital has peaks and troughs. The two areas of troughs below the long-term financing line indicate that there are idle long term funds incurring unnecessary interest cost.

Conservative Approach

Advantage of Conservative Approach

1. Smooth Operation

2. No Insolvency RiskDisadvantage of Conservative Approach

1. Higher Interest Cost

2. Idle Fund

3. Higher Carrying Cost

4. Inefficient working capital Management

Aggressive ApproachThe aggressive approach is a high-risk strategy of

working capital financing wherein short-term finances

are utilized not only to finance the temporary working

capital but also a reasonable part of the permanent

working capital.

In this approach of financing, the levels of inventory,

accounts receivables and bank balances are just

sufficient with no cushion for uncertainty. There is a

reasonable dependence on the trade credit.

Aggressive ApproachFixed assets and a part of permanent working capital are financed by long-term financing sources and the remaining part of permanent working capital and total temporary working capital is only is financed by short-term financing sources. It is explained in the equation below:

Financing Strategy in Equation:Long Term Funds will Finance = Fixed Assets +

Part of Permanent Working Capital

Short Term Funds will Finance = Remaining Part of Permanent Working Capital + Temporary Working Capital

Aggressive Approach Diagram

Aggressive ApproachThe dotted lines horizontal line indicates the point till which the long-term funds will be utilized. The dotted vertical lines indicate the sources of finance and they are tagged as ‘long-term financing’ and ‘short term financing’.We can easily make out that long term funds are financing total fixed assets and a part of permanent assets. A major part of Seasonal requirement or temporary working capital is financed by short term source of finance. In this approach, the difficult area is the part of permanent working capital which is financed by short-term sources. It can pose problems of liquidity and bankruptcy to the firm.

Aggressive Approach

Advantage of Aggressive Approach1. Lower Financing Cost, High Profitability2. Lower Carrying and Handling Cost3. Highly Efficient Working Capital Management

Disadvantage of Aggressive Approach1. Insolvency Risk2. Lost Opportunities and Unexpected Shocks

Matching Approach or Hedging Approach

Maturity matching or hedging approach is a strategy of

working capital financing wherein short term

requirements are met with short-term debts and long-

term requirements with long-term debts.

The underlying principal is that each asset should be

compensated with a debt instrument having almost the

same maturity.

Matching Approach or Hedging Approach

Maturity Matching or Hedging Approach Equation

This matching approach of working capital financing

can be explained in terms of a simple equation as

follows:{

Long Term Funds will Finance = Fixed Assets +

Permanent Working Capital

Short Term Funds will Finance = Temporary

Working Capital

Matching Approach or Hedging Approach

Matching Approach or Hedging ApproachIn the diagram, we can see three levels, each of fixed assets,

permanent working capital and temporary working capital.

The red vertical line with white spaces represents the type of

financing.

The bigger line which stretches till permanent working capital

is long-term financing and a smaller line is the temporary

working capital. The line from where the temporary working

capital starts and the line of a hedging strategy is the same.

Any strategy below this line will be an aggressive strategy and

a strategy above it will be a conservative strategy.

Matching Approach or Hedging Approach

RATIONALE BEHIND MATURITY MATCHING

OR HEDGING APPROACH

Knowing why to apply maturity matching strategy is

very important. It suggests financing permanent

assets with long-term financing and temporary with

short-term financing. Now let us suppose opposite

situations and see. There can two such situations.

Matching Approach or Hedging Approach

1. Permanent Assets Financed with

Short Term Financing

2. Temporary Assets Financed with

Long Term Financing

Management for different components of working capital

1.Cash Management

2.Inventory Management

3.Debtors Management

4.Creditors Management

1.Cash ManagementBusiness concern needs cash to make payments for acquisition

of resources and services for the normal conduct of business.

Cash is one of the important and key parts of the current

assets.

Cash is the money which a business concern can disburse

immediately without any restriction. The term cash includes

coins, currency, cheques held by the business concern and

balance in its bank accounts. Management of cash consists of

cash inflow and outflows, Cash flow within the concern and

cash balance held by the concern etc.

Motives for Holding Cash1. Transaction motiveIt is a motive for holding cash or near cash to meet routine cash requirements to finance transaction in the normal course of business. Cash is needed to make purchases of raw materials, pay expenses, taxes, dividends etc.

2. Precautionary motiveIt is the motive for holding cash or near cash as a cushion to meet unexpected contingencies. Cash is needed to meet the unexpected situation like, floods strikes etc.

3. Speculative motiveIt is the motive for holding cash to quickly take advantage of opportunities typically outside the normal course of business. Certain amount of cash is needed to meet an opportunity to purchase raw materials at a reduced price or make purchase at favourable prices.

4. Compensating motiveIt is a motive for holding cash to compensate banks for providing certain services or loans. Banks provide variety of services to the business concern, such as clearance of cheque, transfer of funds etc.

Cash Management TechniquesManaging cash flow constitutes two important parts:

A. Speedy Cash Collections.

B. Slowing Disbursements.The techniques aim at, the customer who should be encouraged to

pay as quickly as possible and the payment from customer without

delay. Speedy Cash Collection business concern applies some of the

important techniques as follows:

• Prompt Payment by Customers

• Early Conversion of Payments into Cash

• Concentration Banking

• Lock Box System

Slowing DisbursementAn effective cash management is not only in the part of

speedy collection of its cash and receivables but also it

should concentrate to slowing their disbursement of cash

to the customers or suppliers. Slowing disbursement of

cash is not the meaning of delaying the payment or

avoiding the payment. Slowing disbursement of cash is

possible with the help of the following methods:.

1. Avoiding the early payment of cash

2. Centralised disbursement system

Cash Management ModelsBaumol modelThe basic objective of the Baumol model is to determine the minimum cost amount of cash conversion and the lost opportunity cost. Total conversion cost per period can be calculated with the help of the following formula:

t= Tb C

Opportunity cost can be calculated with the help of the following formula;

i = C 2Optimal cash conversion can be calculated with the help of the following formula;

C = 2bT i

where,T = Total transaction cash needs for the periodb = Cost per conversionC = Value of marketable securities

where,i = interest rate earned, C/2 = Average cash balance,

C = Optimal conversion amountb = Cost of conversion into cash per lot or transactionT = Projected cash requirementi = interest rate earned

Management for different components of working capital

Orgler’s modelOrgler model provides for integration of cash management with production and other aspects of the business concern. Multiple linear programming is used to determine the optimal cash management.

Orgler’s model is formulated, based on the set of objectives of the firm and specifying the set of constrains of the firm.

2. Inventory ManagementInventory constitutes a major part of total working

capital. Efficient management of inventory results in

maximization of earnings of the shareholders.

Efficient inventory management consists of managing

two conflicting objectives:

1. Minimization of investment in inventory on the one hand

2. Maintenance of the smooth flow of raw materials for production and sales on the other.

Types of Inventory

1. Raw-Materials Inventory

2. Work-in-Process Inventory

3. Finished-Goods Inventory

4. Stock of Cash

Inventory Management Techniques

1. Economic order quantity

2. Fixation of stock levels

3. ABC Analysis

4. Just in Time (JIT)

Inventory Management Techniques

1. Economic order quantityEconomic Order Quantity (EOQ) is one of the important techniques of inventory management. EOQ represents that level of inventory which minimizes the total inventory cost.

The formula for calculating EOQ is given below:EOQ = √2QA / K

Where, Q = Annual requirement or Production,A = Ordering Cost per order, andK = Carrying Cost per unit per Year.

Inventory Management Techniques

2. Fixation of stock levelsEfficient inventory management requires an effective stock control system. One of the important aspects of inventory control is stock level. Level of stock has a significant bear ing on the profitability. Over-stocking requires large capital investments whereas under-stocking affects flow of the production process. The following are the levels of stock fixed for efficient management of inventory.

Inventory Management Techniques

1. Re-order Level

2. Minimum Stock Level

3. Maximum Stock Level

4. Average Stock Level

Inventory Management Techniques3. ABC Analysis

ABC Analysis is one of the important inventory control

techniques.

In a big manufacturing concern it is not always possible to pay

equal attention to each and every raw material.

In such cases raw materials are classified according to their

value so that proper con trol may be exercised on materials

having high value.

ABC Analysis is an analytical technique that tries to group

materials into three categories on the basis of cost involved.

Inventory Management Techniques3. ABC Analysis

The categories are:

A – High value materials

B – Medium value materials

C – Low value materials

Inventory Management Techniques4. Just in Time (JIT)Just in time (JIT) inventory control system was developed by Taiichi Okno of Japan and was first introduced in Toyata Manufacturing Company of Japan. So it is also known as Toyata Production Method. The basic idea behind this system is that a firm should keep minimum level of inventory on the assumption that suppliers will deliver the raw materials as and when required. This system tries to make inventory carrying cost as zero.

Three important elements of JIT are Just in time purchasing, just in time production and just in time supply. Just in time purchasing, just in time production and just in time delivery can be effectively applied through adoption of advanced manufacturing technology.

4. Accounts Payable Management:Payables or creditors are one of the important components

of working capital. Payables provide a spon taneous source of

financing of working capital. Payable management is very

closely related with the cash management. Effective payable

management leads to steady supply of materials to a firm as

well as enhances its reputation.

It is generally considered as a relatively cheap source of

finance as suppliers rarely charge any interest on the amount

owed. However, trade creditors will have a cost as a result of

loss of enjoying cash discount on cash purchases.

Thank You