Working Capital Concepts

Working Capital Management – An Analysis

CONTENTS

1. Introduction 42. Concept Of Working capital 53. Features Of Working Capital 74. Need For Working Capital 95. Types Of Working Capital 116. Determinants Of Working Capital 147. Optimum Working Capital 178. Management Of Working Capital 199. Management OF Components OF Working Capital 2710. Optimum Credit Policy 3411. Conclusion 3612. Analysis of Working Capital for Durgapur Steel plant

INTRODUCTION :

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Business Capital is broadly divided into two groups: Fixed Capital and Working Capital. Fixed Capital refers to the funds invested in fixed assets of a firm in the form of land, building, machinery etc. Working Capital refers to the funds invested in the current assets of a firm such as raw materials, work-in-progress, finished goods, receivables, cash etc. From the viewpoint of manufacturing process, working capital means that part of capital, which is required to keep the flow of production smooth and continuous.

The main point of difference between the fixed capital and working capital is that : Fixed assets are of long run duration and are not converted within a period of one year, whereas the current assets are converted into cash within a period of one year or less. Hence, the problem of fixed assets belongs to the field of capital budgeting, while the problems of current assets belong to the field of working capital management.

Working Capital, being lifeblood for any enterprise, its management becomes a crutial exercise for the Financial Manager of a firm. The need of working capital is directly linked to the growth of the firm. Working Capital is as essential as fixed assets in the successful operation of a production unit.

In the past, only the problems of the management of fixed capital were given importance in the exercise of financial management. But in the present scenario, looking to the increasing importance of the working capital in any business unit, the exercise of management of working capital has become as much important for a financial manager as the management of fixed capital.

Some authors go the extent of saying that financial management means working capital management. Even if this extreme view is regarded as unacceptable, there is no doubt that a large part of a financial manager’s time and energy is used up in attending to the problems of working capital management.

The exercise of working capital management covers the following points to be considered:

1. Estimating the working capital needs2. Procurement of working capital3. Optimum utilisation of working capital

Before discussing about the management of working capital, first of all, let’s have a brief idea about the concept of Working Capital.

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CONCEPTS OF WORKING CAPITAL :

Working Capital, in the simple words, means the capital invested in the current assets.

However it has been variously defined as :

“Working Capital means the current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivables into cash.” “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 current liabilities.” Thus, there are two different opinions about the meaning of the term working capital.

(1) According to one school of thought, working capital represents all current assets of the Company. They believe that working capital represents those assets, which change their form during the process of production.

Working Capital = Total Current Assets

(2) According to the other school of thought, working capital is the excess of current assets over current liabilities.

Working Capital = Current Assets – Current Liabilities

Current assets include cash, accounts receivable, notes receivable, advances on contracts, inventories etc. Current liabilities include accounts payable, notes payable, accrued expenses, temporary loans etc. Under this concept an attempt is made to measure net working capital of the Company.

To avoid the confusion involved in the interpretation of working capital, the total current assets are described as gross working capital, while the excess of total current assets over total current liabilities are described as net working capital.

Thus, there are two concepts of working capital:1. Gross Working Capital i.e. Total Current assets 2. Net Working Capital i.e. Current assets – Current liabilities

Gross working capital concept focuses attention on two aspects of current assets management:

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a. What is the optimum level of investment in current assets?b. How should current assets be financed?

Net working capital is a qualitative concept. It indicates the liquidity position of the firm and suggests the extent to which the working capital needs may be financed by permanent sources of funds. It indicates how much current assets are covered by current liabilities. The net working capital concept also covers the question of judicious mix of long-term and short-term funds for financing the current assets.

Both gross and net working capital concepts are equally important for the efficient management of working capital.

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FEATURES OF WORKING CAPITAL :

The features of the working capital distinguishing it from the fixed capital are as follows:

Short Term needs

Working capital is used to acquire current assets, which get converted into cash in a short period. The duration of working capital depends on the length of production process, the time that elapses in the sale and the waiting period of the cash receipt.

Circular Movement Working capital is constantly converted into cash, which again turns into working capital. This process of conversion goes on continuously. It moves in a circular way. That is why working capital is also described as circulating capital.

An element of permanencyThough working capital is a short-term capital, it is required always and forever. It is required to run the production activity of the firm smoothly and uninterruptedly. So long as the production continues, the firm will constantly remain in need of working capital.

FluctuatingThough the requirement of working capital is felt permanently, its requirement fluctuates more widely than the fixed capital. The requirement working capital varies directly with the level of production. The portion of working capital that changes with production, sale, price etc. is called variable working capital.

Liquidity

Working capital is more liquid than fixed capital. It can be converted into cash within a short period and without much loss. A firm in need of cash can get it through the conversion of its working capital by insisting on quick recovery of its bills receivable and by expediting sales of its

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products. It is due to this trait of working capital that the firms with a larger amount of working capital feel more secure.

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Less RiskyInvestment in the working capital is less risky as it is a short-term investment. Working capital involves more of physical risk only and that also is limited. It involves financial or economic risk to a much less extent because variations of the product prices are less severe generally. It is also free from technological changes as it gets converted into cash again and again.

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NEED FOR WORKING CAPITAL :

The need of working capital to run the day to day business of a firm can not be ignored. We will hardly find a business firm, which does not require any amount of working capital.

The firm has to maintain an adequate level of current assets to generate sales. The current assets are required, as the sales generated by the firm do not convert into cash immediately. There is always an operating cycle involved in conversion of sales into cash.

Operating Cycle:Operating Cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. It is the time interval between the cash collections from sale of the product and cash payments for resources acquired by the firm. It also refers to the time interval over which the working capital should be obtained in order to carry out the firm’s operations. The operating cycle of a manufacturing company involves three phases:

Acquisition of resources such as raw materials, labour, power and fuel etc.

Manufacture of the product which includes conversion of raw material into work-in-progress into finishes goods

Sale of the product either for cash or on credit. Credit sales create account receivable for collection

Collection of Purchase of Raw receivables Material

Work-in-Progress Sales

Figure 1 Operating Cycle

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Cash

Finished Goods

Accounts Receivable

s

Raw Material


These phases of operating cycle affect the firm’s cash flows : both cash inflows and cash out flows. However these cash flows are neither synchronised nor certain. They are not synchronised because most of the time the cash outflows occurs before cash inflows. Cash inflows are not certain because sale and collections, which gives rise to cash inflows are difficult to forecast accurately. Cash outflows, on the other hand, are relatively certain. The firm is therefore, required to invest in current assets for a smooth, uninterrupted functioning.

The firm’s requirement for working capital, is thus, depends on its operating cycle. For that purpose it needs to forecast the length of its operating cycle.

How to determine the length of the operating cycle?

The length of the operating cycle can be determined by addition of the inventory conversion period and debtor’s conversion period.

The inventory conversion period is the total time needed for producing and selling the product. The debtor’s conversion period is the time required to collect the outstanding amount from the customers. The total of inventory conversion period and debtor’s conversion period is referred to as gross operating cycle.

There are certain expenses, the payment of which can be temporarily postponed. Such types of expenses are the spontaneous sources of working capital for a firm to finance its investment in current assets. The period during which the firm can temporarily defer the payment of such expenses is called as payables deferral period and the difference between the gross operating cycle and the payables deferral period is referred to as net operating cycle.

Based on the forecast of the operating cycle of a firm, its requirement for working capital can be estimated.

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TYPES OF WORKING CAPITAL :

Basically two types of working capital are needed in the business:

1. Permanent Working Capital2. Variable Working Capital These two types of working capital can also be classified as under :

Let’s discuss each of the types in brief:

Permanent Working Capital :This is the minimum level of current assets, which is continuously required by the firm to carry on its business operations. It is permanent in the same way as the firm’s fixed assets are. Depending upon the changes in the production and sales, the need for working capital, over and above the permanent working capital, will fluctuate.

Initial Working Capital :In the initial period of its operation, a firm must need enough money to pay certain expenses before the business yields cash receipt. In the initial years the banks may not grant loans or overdrafts, sales may have to be made on credit and it may be necessary to pay the creditors immediately. Therefor the owners themselves have to

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Working Capital

Permanent Variable

Initial Working Capital

Regular Working Capital

Seasonal Working Capital

Special Working Capital


provide necessary funds in the initial period, which may be known as initial working capital.

Regular Working Capital :The firm is always required to keep certain funds with it to continue the regular business operations, which is called as Regular Working Capital. It is required to maintain regular stock of raw materials and work-in-progress and also of the finishes goods, which must be maintained permanently at a definite level. Regular working capital is the excess of current assets over current liabilities. It ensures smooth operation of business.

Variable Working Capital :This is the working capital which, keeps on changing with the change in the production and sales activities. It is the extra working capital, over and above the permanent working capital, that is needed to support the changing production and sales activities. This type of working capital is also called as fluctuating or variable working capital.

Seasonal Working Capital :Some business operations require additional working capital during a particular season. For example, the groundnut oil producers may have to purchase groundnut in a particular season and have to employ additional labour for that purpose. These may require additional funds for a temporary period, which may be called as seasonal working capital.

Special Working Capital :In all enterprises, some unforeseen events do occur like sudden increase in demand, downward movement of prices of raw materials, strike or natural calamities, when extra funds are needed to tide over such situation. Such type of extra funds is called as Special working capital.

Both the kinds of working capital – permanent and temporary – are necessary to facilitate the production and sales through the operating cycle. However, the temporary working capital is created by the firm to meet the liquidity requirements that will last only temporarily.

The difference between the permanent and variable working capital may be represented in the following two diagrams:

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Temporary or fluctuating

Permanent

Time

Figure 2 Permanent and temporary working capital

Temporary or fluctuating

Permanent

Time

Figure 3 Permanent and temporary working capital

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DETERMINANTS OF WORKING CAPITAL :

There are no set rules or formulate to determine the working capital requirements of a firm. There are ‘n’ numbers of factors influencing the working capital requirements of a firm, which can be briefed as under:

Nature of business :Working capital requirement of a firm is basically influenced by the nature of its business. Trading and financial firms require large amount of working capital. In contrast, the manufacturing firms require less amount of working capital and large amount of fixed assets.

Sales and Demand Conditions :The sales and demand conditions of a firm also affect its working capital position. It is difficult to precisely determine the relationship between volume of sales and working capital needs. Sales depend on the demand conditions. Most of the firms experience seasonal and cyclical fluctuations in the demand of their products and services. These business variations affect the working capital requirement, particularly the temporary working capital requirement of the firm.

When there is an upward swing in the economy, the sales will increase and untimely the firm’s investment in inventories and debtors will also increase. On the other hand, when there is a decline in the economy, the sales will fall and ultimately, the level of inventories and debtors will also fall. Under recessionary conditions firms try to reduce their short-term borrowings.

Technology and Manufacturing Policy :The manufacturing cycle of the firm also affects the requirement of the working capital. The manufacturing cycle comprises the purchase and use of raw material and production of finished goods. Longer the manufacturing cycle, larger will be the firm’s working capital requirements and vice versa. An extended manufacturing time span means a larger tie-up of funds in inventories. Thus, if there are alternative technologies for manufacturing a product, the technological process with the shortest manufacturing cycle may be chosen.

Further, the requirement of working capital also depends on whether the firm has adopted steady production policy or variable production policy.

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Credit Policy :In the present day circumstances, almost all units have to sell goods on credit. The nature of credit policy is an important consideration in deciding the amount of working capital requirement. The larger the volume of credit sales, the greater will be the requirement of working capital. Also the longer the period of collection of payment, the greater will be the requirement of working capital. Generally, the credit policy of an individual firm depends on the norms of the industry to which the firm belongs.

Availability of Credit :The availability of credit from banks and financial institutions also influences the working capital requirement of a firm. The availability of credit to a firm depends upon the creditworthiness of the firm in the money market. If a firm has good credit standing in the market, it can get credit easily on favorable terms and hence it will require less working capital.

Operating Efficiency :The operating efficiency of the firm relates to the optimum utilisation of resources at minimum costs. If the firm is efficient in controlling its operating costs and utilizing its current assets, than it helps in keeping the working capital at a lower level. The use of working capital is improved and pace of cash conversion cycle is accelerated with operating efficiency.

Price Level Changes :The price level changes also affect the level of working capital. Generally, rising price levels will require a firm to maintain higher amount of working capital. However, the effect of rising prices may be different for different companies, as though the general price level increases, the individual prices may move differently. Therefor some firms may require more working capital, while other may require less working capital in case of price rise.

Growth and Expansion Plans :The growth and expansion plans to be undertaken by a firm also affect its requirements of working capital. Hence the planning of the working

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capital requirements and its procurements must go hand in hand with the planning of the growth and expansion of the firm. Even the expansion of the sales also increases the requirements of working capital.

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OPTIMUM WORKING CAPITAL :

A firm has to maintain an adequate level of working capital to run its operations smoothly and effectively. It should be adequate in the sense that it shall not be more than the requirements nor it shall be less than the requirements. Both the excessive as well as inadequate working capital positions are dangerous from the firm’s point view.

We know that the current liabilities are met out of the current assets. So the level of current assets shall be sufficient enough to meet the current liabilities. Excessive working capital refers to the position where when the level of current assets is much higher to meet current liabilities. The excessive capital has opportunity cost for the firm, as this excessive capital remains idle in the firm, which earns no profit for the firm. If these funds shall be invested in some profitable project, it adds the profitability of the Company.

On the other hand, inadequate working capital refers to the position where the current assets are not sufficient enough to meet the current liabilities. Such type of position may be harmful to the firm as it may interrupt the production and sales of the Company, which ultimately affects the profitability of the Company. Moreover if the liquidity position of the firm is not adequate enough to meet its current liabilities, it may affect its credibility in the market.

Therefore an enlightened management should maintain the right amount of working capital on a continuos basis. Only then the proper functioning of business operations can be ensured. The amount of the working capital shall be maintained at such level, which is adequate for it to run its business operations, neither excessive nor inadequate. This level of working capital is called as the “Optimum Working Capital”.

Risk – Return Trade-off : Liquidity v/s Profitability: The level of working capital affects the degree of risk and profitability both. Hence the level of working capital should be so fixed that, on the one hand, its financial soundness is maintained and on the other hand, its profitability is optimised.

At this point it is necessary to be clear about the meaning of solvency or insolvency of the firm. Solvency means a situation in which a firm can easily repay its debts as and when they mature. On the other hand, insolvency is a situation in which a firm is not able to repay its debts as and when they become due for payment.

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The term risk implies the profitability that a firm will become technically insolvent, so that it will not be able to meet its obligations as and when they become due for payment.

Nature of trade-off:

If profitability is to be increased, the firm must increase its risk. If the firm wants to decrease risk, its profitability will also decrease. If a firm wants to maintain insolvency, it must maintain a higher level of liquidity. That is, it must hold a larger amount of current assets such as cash, receivables, stock of goods etc., so that there would be no problem in repaying the debts as and when they due for payment. However, if a firm holds more amount of current assets, the prospects of profit decline due to the fact that most of its funds are locked up in idle current assets, which earn no profit.

On the other hand, if a firm wants s to increase its profitability, it must be prepared to increase its risk of insolvency, as it would have to reduce its investment in current assets. However a smaller amount of liquidity increases risk of insolvency and, at the same time, it increases profitability also.

The firm should maintain the its current assets at such level that on the one hand its profitability increases and on the other hand its risk of insolvency decreases. There should be a balance between profitability and risk. The level, at which there is a trade-off between the risk and return, is the optimum level of working capital for a firm.

The following figure will clear the idea about the Risk – Return Trade-off of a firm:

Optimum Working Capital

Return / Profitability

Figure 4 Risk – Return Trade-off

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Ris

k / L

iqu

idity


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MANAGEMENT OF WORKING CAPITAL :

Working Capital management refers to the administration of all aspects of current assets namely cash, marketable securities, debtors and stock (inventories) and current liabilities. The financial manager should determine levels and composition of current assets. He must see that right sources are tapped to finance current assets and that current liabilities are paid in time.

Working capital management is critical for all firms, but particularly for small firms. A small firm may not have much investment in fixed assets, but it has to invest in current assets. Further, the role of current liabilities in financing the current assets is far more significant in case of small firms, as, unlike large firms they, face difficulties in raising long-term finances.

The main problems of the management of working capital are as stated below:

a. to determine a proper amount of working capital to be held in the business i.e. estimating the working capital needs

b. to take decision on the sources of working capital i.e. procurement of working capital

c. to ensure that the working capital is efficiently utilised i.e. optimum of utilisation of working capital

Before we consider these problems lets first understand some of the principles of working capital management:

Principles of Working Capital Management :

The financial manager must keep in mind the following principles of working capital management:

Principle of Optimisation :The level of working capital must be so kept that the rate of return on investment is optimised. In other words, the working capital should be maintained at an optimum level. This is the point at which the increase in cost due to decline in working capital is equal to the increase in the gain associated with it.

According to the principle of optimisation, the magnitude of working capital should be such that each rupee invested adds to its net value. In other words Capital should be invested in each component of working capital as long as the equity position of firm increases.”

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Principle of Risk Variation :This principle is based on the assumption that the rate of return on investment is linked with degree of risk in the business. The greater on investment is linked with the degree of risk in the business assumes, the greater is the opportunity for gain or loss.

Principle of Cost of Capital :Each source of working capital has different cost of capital. The degree of risk also differs from one source to another. The type of capital used to finance working capital directly affects the amount of risk that a firm assumes as well as the opportunity for gain or loss and cost of capital. A firm should raise capital in such a manner that a balance is maintained between risk and profit.

Principle of Maturity of Payment :This principle states that the working capital should be so raised from different sources that the firm is able to repay them on maturity out of its inflows of funds. Otherwise the firm would fail to repay on maturity and ultimately, it would find itself into liquidation though it is earning huge profits. This implies that the firm’s ability to repay its short-term debts depends not on its earnings but on the flow of cash into it.

These are some of the principles of working capital, which a financial manager should keep in mind while managing working capital. Now let’s discuss how to manage working capital.

Estimating Working Capital needs :

The first step in managing working capital is to estimate about the working capital needs. The most appropriate method for calculating working capital needs of a firm is the concept of operating cycle.

In estimating working capital needs, different people adopt different approaches. Some authors suggest that the working capital should be greater than the minimum requirements of the firm. The management should feel safety. It would be able to meet its obligations even in adverse circumstances. However, the excessive capital may lead to waste and inefficiency.

On the other hand, many authors suggest that the working capital should be lower than the requirement so that no idle funds shall be invested in the current assets and it ultimately leads to increase in

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profitability of the Company. However, in such case the firm always have risk of technical insolvency as it may not meet its obligations as and when they falls due for payment.

So the question is what the proper amount of working capital is. It is not an absolute amount. It depends upon the needs and circumstances available in the firm.

There are various approaches which have been applied in practice for estimating the working capital needs of a firm. Let’s discuss some of them in brief.

Conservative Approach:The conservative approach states that the proportion of current assets to current liabilities should be kept at 2:1. Is this proportion is to be kept the firm would be able to meet its obligations on time and hence its financial solvency would not be in trouble. However, the limitation of this approach is that it suggests only quantitative measure. It does not suggest as to what type of assets are to be included in current assets. If the current assets contain stock, which is outdated or receivable which are not collectable, than the amount of current assets has no meaning. Further, in the present scenario no firm maintains this ratio, as it’s too difficult for them to maintain such a high level of current assets.

Objective Test:Some objective tests are suggested for determining the level of working capital of a firm. On the basis of answer to the following questions, it can be determined whether the level of working capital is adequate or not:

1. Whether the Company is able to make cash purchases and can avail of cash discounts.

2. Whether the Company has enough credit worthiness to get finance from Banks easily as and when needed?

3. Whether the creditors allow enough credit on purchases?

4. Whether the Company experiences any difficulty in paying dividend?

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Modern Approach :Apart from the conventional methods for estimating the need for working capital, the following two methods are used in the modern enterprises for the purpose:

1. Ratio of Current Assets to Fixed Assets2. Current Asset holding period

Let’s have a brief idea about each of them.

1. Ratio of Current Assets to Fixed Assets

The financial manager should determine the optimum level of current assets so that the wealth of shareholders is maximised. In a business enterprise both fixed and current assets are needed to support a particular level of output. However, to support the same level of output, the firm can have different levels of working capital. The level of current assets can be measuring the current assets to fixed assets i.e. by measuring the ratio of current assets to fixed assets.

Dividing current assets by fixed assets gives the ratio of Current Assets to Fixed Assets.

From the viewpoint of this ratio, there are three types of approaches:

A. Conservative approach

Many firms maintain a high ratio of current assets to fixed assets so that they may not have any difficulty even in crisis. It suggests greater liquidity and lower risk. Risk adverse firms mainly adopt this approach.

B. Aggressive approach

Many firms maintain low ratio of current assets to fixed assets, so that their funds may not block idle and they can be used for some profitable purpose. It involves higher risks and smaller liquidity.

C. Average Capital approach

Most of the firms maintain their current level between these two extreme levels. This is an average capital approach. This involves moderate liquidity and moderate risk.

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AAAAAA

Figure 5 Alternative Current Asset Approaches

2. Current Assets holding period

In this method the working capital requirements are to be estimated on the basis of average holding period of current assets and relating them to costs based on the firm’s experience in the previous years. This method is essentially based on the operating cycle concept.

A modified version of this method is also used by various firms, in which the current assets are carefully estimated and at the same time the current liabilities are also to be estimated. The difference between two gives a rough idea about the net working capital requirements of the firm.

Let’s have a brief idea about how various components of current assets and current liabilities are to be estimated for estimating the working capital requirements:

1. Stock of Raw Materials =

No. of Units Produced * Per Unit Cost of raw materials * Average holding period of raw materials

2. Work in Progress = i. Materials : No. of Units Produced * Per Unit

Cost of raw materials * Average period of raw materials in process

ii. Labour : No. of Produced * Per Unit Cost of Labour * Average of period of labour in process

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A. Conservative Approach

B. Average Approach

C. Aggressive Approach

Output

Le

vel o

f Cur

rent

Ass

ets


iii. Overhead: No. of Produced * Per Unit Cost of Overheads* Average of period of Overheads in process

Generally, the WIP is to be taken as half a month’s raw material cost and one month’s labour and variable cost.

3. Finished Goods =

No. of Units Produced * Per Unit Total Cost

4. Sundry Debtors =

No. of Units Sold * Period of credit given to debtors * Total Cost of Production

Profit is not to be considered for calculating the outstanding debtors. On the same way only the sales which are made on credit are to be considered. Thus the cash sales are to be deducted before estimating the debtors.

5. Sundry Creditors =

No. of Units Produced * Per unit cost of raw materials * Credit period allowed by the suppliers

6. Outstanding Wages and Overheads =

No. of Units Produced * Per unit cost of Wages and Overheads * Time leg in payment of Wages and Overheads

After estimating the components of current assets and current liabilities a Statement Showing the Working Capital Requirement is to be prepared as under:

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Statement Showing Requirement of Working Capital

Particulars Rs. Rs.Current Assets :1. Stock of Raw Materials 2. Stock of Work in progress : Material Cost ---------- Wages ---------- Overheads ----------3. Stock of Finished Goods (at cost of

production)4. Debtors 5. Minimum Cash required6. Advance Payments

Total Current Assets (A)

----------

--------------------

------------------------------

-------------

Current Liabilities :1. Creditors for purchases2. Outstanding wages and overheads 3. Advance received from customers

Total Current Liabilities (B)

----------------------------

-----------

Total Working Capital Requirement (A – B) -----------

These are some of the methods that are used in estimating the working capital requirements. After estimating the working capital requirements, the second step for financial manager is to think about the procurement of working capital.

Let’s see how a financial manager decides about the procurement of working capital.

Procurement (financing) of Working Capital:

The second step in managing the Working Capital is to take into consideration the various sources from which a working capital can be procured and to decide about the best suitable source for procurement of Working Capital.

Generally, it is believed that funds for acquiring the Fixed Assets should be raised from long term sources and short-term sources should be utilised for raising working capital. But in the recent modern enterprises, both the types of sources are utilised for financing both fixed and current assets.

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There are different approaches for determining the proportion in which the short term and long term sources shall be used to finance fixed assets and current assets. There are three approaches:

1. Hedging Approach:

Under this approach, the funds for acquiring fixed assets and permanent current should be acquired with long term funds and for temporary working capital short term funds should be used.

2. Conservative Approach:

This approach suggests that in addition to fixed assets and permanent current assets, even a part of variable current assets should be financed from long-term sources. The short-term sources are used only to meet the peak seasonal requirements. During the off season, the surplus fund is kept invested in marketable securities. This approach depends upon the long-term sources to a great extent.

3. Aggressive Approach:

This approach depends more on short-term funds. More short-term funds are used particularly for variable current assets and a part of even permanent current assets, the funds are raised from short term sources.

The main sources from which the working capital can procured are as under:

1. Shares and Debentures2. Retained Profits 3. Commercial Banks by way of loan, cash credit etc. 4. Trade Creditors 5. Public Deposits 6. Indigenous Bankers and Money-lenders7. Urban Co-operative Banks

The financial manager should decide about the best suitable source for procuring the working capital, as each source has its own pros and cons.

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MANAGEMENT OF COMPENENTS OF WORKING CAPITAL :

The financial manager of a firm shall, while thinking about the management of working capital, consider the management of the following components of working capital individually:

1. Cash Management 2. Inventory Management 3. Receivable Management

The exercise of management of each component of Working Capital leads to effective management of Working Capital of a firm.

Let’s have a brief idea about the management of each component of working capital.

1. Cash Management :

Cash is the medium of exchange which allows management to carry on the various activities of the business on day to day basis. It includes coins, currency, cheques held by the firm and the balance in its bank accounts. In a broader sense, it also includes “Near Cash Assets” such as marketable securities and time deposits with the bank.

A firm should have a sufficient balance of cash neither more nor less than the requirements. A firm holds cash for the following motives :

a) Transaction Motive, b) Precautionary Motive, c) Speculative Motive and d) Compensating Motive.

The cash management of a firm involves the consideration of the following four factors :

Ascertainment of the minimum cash balance and controlling the levels of cash

Controlling cash inflows Controlling cash outflows Optimum investment of surplus cash

Controlling the levels of cash :The financial manager of a firm shall have the following tools available with him for controlling the levels of cash.

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Preparing Cash Budget:

Cash budget is a statement showing the estimated cash inflows and cash outflows over the next planning period. The surplus or shortfall of cash is highlighted by the cash budget.

Providing for contingencies:

In addition to the level of cash determined by the cash budget, a suitable minimum amount of cash must be kept for meeting the unforeseen contingencies such as strikes, floods, fire etc.

Consideration of cost of shortage of cash:

The cost arises in terms of loss of firm’s reputation or additional cost of borrowing at higher rate of interest shall be considered.

Availability of other sources of funds:

In case of shortage of cash, which are the sources that can be trapped for meeting the urgent cash requirements.

Controlling of cash inflows:

After having prepared the cash budget, a finance manager must ensure that there is no significant deviation between the projected cash inflows and the actual cash inflows. Effective cash collection shall be made by adopting the following techniques.

Concentration Banking :

The Concentration Banking is a system of decentralised collection of accounts receivable in case of large firms having their business spread over a large area, by opening a number of collection centers at selected strategically located areas and making collections from that centers from the customers residing in that area.

Local Box System :

In this system, the firm hires a post-office box and asks its customers to send the cheques to the box. The firm’s local bank is given authority to open the box and credit the payment in the firm’s bank account.

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Controlling of cash outflows:

The operating cash requirement can be reduced by controlling the cash outflows. The financial manager can use the following techniques for the purpose.

Centralised Disbursements :

All the payment can be made from only one account at the Head Office. This will result in delay in presentation of cheques for payment by parties who are working from distant places.

Playing ‘Float’ :

‘Float’ means the amount tied up in cheques that have been drawn but have not yet been presented for payment. There is always a time lag between the issue of a cheque by the firm and its actual presentment for payment. As a result the firm’s actual balance at bank may be more than the balance as shown by its books. This different is called “Payment in Float”.

Optimum Investment of Surplus Cash :

The financial manager shall use it’s the cash efficiently and for that purpose, the following points shall be kept in mind.

Determining Surplus Cash :

Surplus cash is the cash in excess of the firm’s normal cash requirements. This requirement can be computed by the multiplication of desired days of cash and average daily outflows. If the cash balance is more than this normal requirement, then the surplus cash can be invested somewhere to earn returns.

Determining Channels of Investment :

Surplus funds can be invested in marketable securities or somewhere else. While exercising such discretion, a finance manager must take care of security, liquidity, yield and maturity associated with marketable securities.

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2. Inventory Management :

Inventory is composed off the assets that will be sold in future in the normal course of business operations. To the finance manager, the inventory connotes the value of raw materials, consumables, spares, work-in-progress, finished goods and scrap in which the firm’s funds have been invested.

A firm holds inventory mainly for the following motives:

a. Transaction Motive b. Precautionary Motivec. Speculative Motive

As the inventory involves the investment of the funds, it should be managed properly or rather controlled properly. Inventory management is a planned method to determine which items is to be purchased and how much to be kept in stock, so that the costs of purchase and storage both are minimised without adversely affecting either production or sales. It involves the decision of the firm as to the extent to which inventories can be economically stored.

The inventory hold by the firm involves the following cost to the firm:

a. Ordering Costs:

Every time an order is placed for stock replenishment; certain costs are incurred called as ordering cost. It includes paper work costs, follow up costs, staff costs etc.

b. Carrying Costs:

Carrying costs are the costs of holding inventory for a given period of time. It includes storage cost, handling cost, insurance cost, obsolesce cost etc.

Objectives of Inventory Management:

A fundamental objective of a good system of inventory management is to be able to place an order at the right time from the right source to acquire the right quantity at a right price and of right quantity.

Mainly there are the following objectives of the Inventory Management:

1. to ensure adequate stock2. to minimise inventories on hand 3. to maintain continuity in production4. to minimise the cost of purchasing and storage

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5. to minimise the wastage and loss6. to reduce the risk of deterioration7. to use the available capital effectively8. to be helpful in efficient purchasing9. to give maximum satisfaction to customers10. to minimise loss due to price decline11. maximum use of storage capacity12. proper storage of materials

Techniques for Inventory Management:

Usually the following techniques are being used by the financial manager for inventory control.

a. Determining the Economic Order Quantity(EOQ):

Economic Order Quantity is that quantity at which the total ordering costs and inventory carrying costs will be the minimum. A firm is required to consider a number of factors before fixing an economic ordering quantity. Of these factors, important ones are inventory carrying costs and ordering costs.

When the inventory carrying cost and ordering cost are in balance, the total cost of ordered quantity is lowest and therefore it is called as economic order quantity. The firm should maintain its inventory at such a level so that its inventory carrying cost and ordering cost are at balance.

There are three methods for determining the EOQ:1. Graphic Method2. Formula Method 3. Trial and Error Method

The results of all three methods are more and less same.

b. Determining other inventory levels:

In order that the inventory costs are reduced to the minimum and yet the process of production and sales goes on uninterrupted, it is necessary to determine the following inventory levels:

1. Re-order Point or Ordering Level

It represents the quantity level at which an order for fresh supplies must be placed with the supplier to replenish the present stock.

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Generally the following formula is to be used for the purpose:

Ordering Level = Maximum Consumption * Maximum Delivery Time

2. Minimum Level

The minimum level indicates the lower level of stocks of inventory.

Min. Level = Re-ordering level – Average Consumption of Average Delivery Period

3. Maximum Level

The maximum level of inventory indicates the upper limit of level of stocks. It represents the largest quantity of material to be kept in stock.

Max. Level = Re-ordering level – Minimum Consumption of Minimum Period + Re-ordering Quantity

c. ABC System of Inventory Control :

A modern system of inventory control, which is economical, too is ABC System of inventory control. It is Always Better Control (ABC).

Some items included in the inventory are of very low value and its detailed accounting is not economical. Hence, such items must be stored in sufficient quantity and its use is not restricted. On the other hand, there are certain items of inventory that represent a large proportion of the total value of inventory.

In ABC Analysis all items are divided into three categories A, B and C.

In category A, are included those items which are very important and of high value but forms only a small proportion of total quantity of inventory. Strict control over receipts, storage and issue should be exercised over such items. Its requirements must be estimated in advance and its purchases must be planned, so that it is available as and when needed.

In category B, those items are included, which are not as important as those are in A group, but are important

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enough for its proper records to be maintained. Maximum and Minimum levels must be fixed for such items and they must be issued against proper material requisition only.

The remaining items must be places in Category C. They are not important from the view point of maintaining control over their receipts and consumption. Little control is to be put on such items.

The ABC System of inventory control is very useful for the modern management as it helps in saving their time from the unnecessary work and leads to efficient inventory control.

d. Perpetual Inventory System :

For efficient inventory control, it is necessary that the various items of inventory must be continuously checked and compared with records maintained. This is done by Perpetual Inventory System.

Perpetual Inventory means a system of maintaining continuous stock records through bin cards and stores ledger. This implies continuous stock taking in which a certain number of inventory items are checked and verified everyday or at frequent intervals.

3. Receivables Management :

When the goods are sold on credit in business, the price of the goods becomes receivable. In the present economic system, credit sales are essentials, unless the goods sold are in short supply. The money involved in inventories are blocked till future and therefore there is an opportunity cost of receivables. However, the credit sales are also essential in order to meet the sever competition. Thus, the management of receivable requires great care. It must be so managed that the benefit available from additional sales and the cost of funds raised to finance the additional credit coincide.

The management of receivables is important in the sense that in India it forms about one-third of current assets. The management of receivable is needed as; a firm has to incur the following cost associated with receivables.

1. Collection Cost i.e. the costs incurred in collecting the payments 2. Default Cost i.e. the bad debt losses arise when a firm is unable

to collect some receivable3. Opportunity Cost 4. Administrative Cost

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Optimum Credit Policy :If a firm sells goods on credit, it has to decide the optimum credit policy. It has neither to be too rigid nor too liberal. The sales must go on rising and yet the bad debts and collection costs are kept to the minimum.

Thus two types of credit policies are to be considered:

1. Liberal or Lenient Credit Policy2. Strict or stringent credit policy

In Liberal Credit Policy, the customers are allowed liberal terms for credit sales and credit is granted for a longer period even to those customers whose financial position is doubtful. A liberal policy results into increase of sales and increase of profits. However, the risk of bad debts and the opportunity cost of receivables are also increased. The collection costs are also increased.

On the other hand, a strict or stringent policy implies that the firm sells in credit on a highly selective basis and only to those customers whose financial position is sound. It results into reduction in sales and reduction in profit also. However, the cost involved with the high volume of receivables and risk of bad debts are also reduced.

The firm should determine its credit policy in such a manner that on one hand its profitability is to be increased and on the other hand its liquidity position is not hampered. That means the point at which the profitability and liquidity is balanced is the optimum credit policy for the firm.

Credit Policy Variables :While framing optimum credit policy, the financial manager shall consider carefully the following variables of the credit policy:

a. Credit Standards

Credit Standards means the criteria on the basis of which, credit is granted to a particular customer or particular group of customers. If the standards are very strict in would reduce the volume of receivables and vice versa.

Credit Standards of most of the firms include the creditworthiness of the customer. That means the credit should be granted to a customer after accessing his credit worthiness.

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For accessing the creditworthiness of a customer two factors are important :

i. average collection period of a particular customer ii. his default rate

While determining the creditworthiness of a customer five C’s are taken into account:

i. Character ii. Capacityiii. Collateraliv. Condition and v. Capital

b. Credit Terms

Credit terms means both the credit period and the cash discount offered, the credit period is the length of time for which credit is extended to customers. It is stated by such terms as “3/15 Net 45” meaning that if payment is made within 15 days, 3% cash discount will be given. Even without discount, payment will be made within 45 days. Generally, the customers of the industry determine the credit terms.

c. Collection Policy

The collection policy must be such as would help in collecting book-debts in time and reduce the bad debts. A collection policy should ensure prompt and regular collection. This would reduce the need for more working capital and loss of bad debts. The firm must frame a procedure to expedite collection from the customers.

e.g. First, a letter must be written to the customer to pay his dues. If he does not respond, then a strong letter must be written. As a last step, a letter must be sent informing the customer that legal action would be taken is dues are not paid within certain days.

Thus, a financial manager of a firm shall, while managing its working capital, consider carefully the management of the components of the working capital, in the manner as stated above.

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CONCLUSION:

Working Capital occupies a peculiar position in the Capital Structure of a firm. It is the life-blood of all types of enterprises, manufacturing and trading both. If the business has enough Working Capital, it can maintain its operating efficiency. Not only that, but adequate working capital provides psychological satisfaction and relief to the management. Only those enterprises, which have adequate working capital, can survive in times of depression. It has been observed that number of business enterprises have failed due to inefficient management of working capital.

That is the reason why the management of working capital becomes a tedious exercise for a financial manager of a firm. For any enterprise the question of adequacy of working capital and its efficient management is a test of efficiency of a financial manager. The experience shows that much of the financial manager’s time is used in the management of working capital.

Working Capital constitutes a large portion of total investment in assets. It is estimated that about 60% of the total net assets of the public sector companies in India is in the form of current assets. This underlines the importance of the working capital management.

Working Capital management is more important for small firms also. Generally, in the small units, investment in such current assets as cash, receivables and inventories tends to be larger than investment in fixed assets. Also it is more difficult for small units to raise enough long term capital for the current assets.

Therefore, the exercise of the management of working capital must be taken with great care and attention. The financial manager must be constantly alert to ensure that there is no over investment in working capital. On the other hand, he also has to ensure that the firm does not face the problem of shortage of working capital. The financial manager has to constantly make efforts to ensure that whatever working capital the firm possess, is managed properly so as to increase the operating efficiency of the firm.

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CALCULATION OF WORKING CAPITAL FOR BHILAI STEEL PLANT

(In crores)

YEAR 2004-05 2005-06 2006-07 2007-08

CURRENT ASSETS:

INVENTORIES 1041.68 1505.76 1556.66 1712.9

SUNDRY DEBTORS 19.48 20.53 18.82 13.7

CASH & BANK 22.35 33.81 36.8 39.86

INTEREST RECEVIABLE 18.89 16.55 13.86 12.6

LOANS & ADVANCES 194.82 218.44 325.12 480.72

TOTAL CURRENT ASSETS 1297.22 1795.09 1951.26 2259.78

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CURRENT LIABILITIES:

CURRENT LIABILITIES 894.57 850.16 910.08 1190.59

PROVISIONS 93.98 103.46 79.37 82.42

TOTAL CURRENT LIABILITIES 988.55 953.62 989.45 1273.01

NET WORKING CAPITAL 308.67 841.47 961.81 986.77

CHART SHOWING WC OF BSP:

CALCULATION OF WORKING CAPITAL FOR ROURKELA STEEL PLANT

(In crores)

YEAR 2004-05 2005-06 2006-07 2007-08

CURRENT ASSETS:

INVENTORIES 500.44 718.11 877.56 870.13

SUNDRY DEBTORS 12.44 14.6 12.96 11.66

CASH & BANK 15.75 17.22 18.79 20.66


LOANS & ADVANCES 195.93 212.72 230.94 243.15


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PROVISIONS 50.52 49.57 50.78 48.35



CHART SHOWING WC OF RSP:

CALCULATION OF WORKING CAPITAL FOR BOKARO STEEL

(In crores)

YEAR 2004-05 2005-06 2006-07 2007-08

CURRENT ASSETS:

INVENTORIES 953.87 1365.56 1407.49 1185.74

SUNDRY DEBTORS 11.13 12.51 8.95 7.74

CASH & BANK 35.77 37.9 41.08 44


LOANS & ADVANCES 255.87 391.18 390.9 587.45


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PROVISIONS 99.22 94.82 53.99 48.27



CHART SHOWING WC OF BSL:

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Working Capital Concepts

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