Working Capital Managemnt Module 1 Afm

8/8/2019 Working Capital Managemnt Module 1 Afm

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Working Capital

Management

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WORKING CAPITAL Working capital refers to that part of total

capital, which is used for carrying out the

regualr business in other words its used

for financing the day-to-day operations of

the business

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Classifications of WCClassifications of WCConsidering the objectives and scope of working capital, it canbe defined in two ways:

(i) Gross Concept(ii) Net Concept

(i) Gross Concept:- According to the gross concept, workingcapital means total of all the current assets of a business. It is

also called gross working capital.Gross Working Capital= Total Current Assets

(ii) Net Concept:- According to the net concept of workingcapital, net working capital means the excess of current assetsover current liabilities. If current assets are equal to currentliabilities then according to this concept working capital will be

zero and in case current liabilities are more than current assets,the working capital will be called negative working capital.

Net Working Capital= Current Assets-Current Liabilities

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Permanent or fixed working capital is a certain minimum

level of capital maintained on a continuous anduninterrupted basis

The business process does not come to an end after the

realization of cash from customers so there is a

continuous need for WC Any amount over and above the permanent level of WC

is temporary or fluctuating or variable WC

So therefore temporary WC is the WC needed to meet

seasonal as well as unforeseen requirements

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Permanent Working CapitalPermanent Working Capital

Permanent current assetsPermanent current assets

DOLLAR

AMOU

NT

The amount of current assets required to meet a firms long-termThe amount of current assets required to meet a firms long-term

minimum needs.minimum needs.

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Temporary Working CapitalTemporary Working Capital

Permanent current assetsPermanent current assets

TIME

Temporary current assetsTemporary current assets

The amount of current assets that varies with seasonal requirements.The amount of current assets that varies with seasonal requirements.

A

M

O

U

N

T

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Positive and Negative Working

Capital The positive working capital represents the excess

of current assets over current liabilities

Sometimes the net working capital is negative whencurrent liabilities are exceeding the current assets.

The Negative working capital position will

adversely affect the operations of the firm and its

profitability. It may lead to technical insolvency.

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WORKING CAPITAL

MANAGEMENTWorking Capital Management:

It is the management of all aspects of both current assets andcurrent liabilities, so as to minimize the risk of insolvency whilemaximizing return on assets.

The primary objective of working capital management is to ensurethat sufficient cash is available to:

meet day-to-day cash flow needs;

pay wages and salaries when they fall due; pay creditors to ensure continued supplies of goods and services; pay government taxation and providers of capital.. dividends; and ensure the long term survival of the business entity.

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Working capital management is concerned with the

problems that arise in attempting to manage the current

assets and current liabilities and the relationship that existbetween them.

The goal of WCM is to manage the firms CA and CL in

such a way that a satisfactory level of WC is maintained

In other words WCM is concerned with maintaining

adequate amount of working capital

adequate amount of working capital refers to optimum

amount of WC which is neither too high nor too low. Both

excess and inadequate WC are dangerous for any firm.

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It is critical to understand that Profit is not Cash. A

company can be very profitable but it can collapse simplybecause it has insufficient cash/liquidity to pay its relevantbill (as stated above).

Always remember that any companys liabilities are settledwith cash and not by profit.

Importance in Optimizing Working CapitalManagement:

Poor working capital management can lead to: over-capitalisation; and overtrading

Characteristics of over-capitalisation are excessive stocks,debtors, and cash, low return on investment with long termfunds tied up in non-earning short term assets.

Overtrading leads to escalating debtors and creditors, andif unchecked, ultimately to cash starvation.

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BENEFITS OF ADEQUATE WC

Its an index of the solvency of the firm

It enhances the credit worthiness of the firm

It helps the firm to maintain good business relations It helps the firm to avail cash discounts facilities offered

by suppliers

It improves the morale of the executives and the

employees of the firm

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DEMERITS OF EXCESS WC It results in idle funds and the there by lowers the profitability of the

business

It takes the form of unnecessary accumulation of inventories, there

may be misleading wastage theft etc of the stock, which again reduces

the profits of the business If it takes the form of huge account receivables, the inference is that

the credit worthiness of the firm is defective and the collection of debt

is not efficient this leads to bad debts, which ll affect the firms

profitability

It makes mgt self satisfied in their work thus contributing to managerialinefficiency

High liquidity may induce a company to undertake greater production,

which may not have a matching demand in the market

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DANGERS OF INADEQUATE WC

Its not possible to utilize production facilities fully The company may not be able to take the advantage of cash

discount facilities

The credit worthiness of the company is likely to jeopardize due

to lack of inadequate WC A company may not be able to take the advantage of profitable

business opportunities

Its difficult to execute operating plans to achieve target profit

Its difficult to meet day to day commitments

A firm may not be able to enjoy the attractive credit terms from

suppliers and creditors

It causes interruption in production

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DETERMINANTS OF WC

REQUIREMENTS General nature of business Scale of operations Growth and expansion length of manufacturing process

Production policies

Rapidity of turnover

Seasonal fluctuations in demand

Fluctuations in supplies

Operating efficiency

Credit policies

Price level changes

Government regulations

Profit level

Taxes

Depreciation policies

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DETERMINING FINANCING MIX

The important decision involved in WCM is how currentassets are financed

Financing mix is the choice of financing of current assets

The two sources from which funds can be raised for

current asset financing areshort term sources(current liability)

long term sources

(shares,debentures,borrowings,retained earnings)

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What proportion of current assets must be

financed by current liabilities and whatproportion by long term resources?

Decisions on such questions will determine

the financing mix..

the 3 basic approaches to determine an

apporpriate financing mix are.

hedging or matchin approach

conservative approach

trade off between these two

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Hedging approach Hedging is used in sense of risk-reducing investment strategy, involving

transactions of simultaneous but opposing nature so that effect of one is likely tocounterbalance the effect of other

Hedging approach is the process of matching the maturity of debt with maturity

of financial needs

According to this approach maturity of sources of fund should match the nature

of asset to be financed. So CA can be classified into two

do not vary over time

fluctuate over time

According to this approach..

Use long term funds to finance fixed portion of CA(permanent) requirement and

Use short term funds to finance temporary or seasonal requirement

So here requirements of total funds are divided into seasonal and permanentcomponents, each being financed by a different source.

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Permanent needs implies financing needs

for fixed assets plus permanent portion of

current assets which remain unchanged

over the years

Seasonal needs implies the financing

requirements for temporary current assets

which vary over the year

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Conservative approach

This approach suggest that the estimatedrequirement of the total funds must be met

from long term sources only, and the use

of short term funds should be restricted to

only emergency situations or unexpected

outflow of cash

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A trade off between hedging and

conservative approach

The hedging approach is associated with high

profits and high risk

While the conservative approach is associated

with low profits and low risk. Obviously neither approach by itself would serve

the purpose of efficient WCM

A trade off btwn these two extremes would give

an acceptable financing strategy

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PLANNING WORKING CAPITALNEED FOR WORKING CAPITAL

Need for WC or CA cannot be overemphasized.

The objective of financial decision making to maximize the sh/h wealth,

its necessary to generate sufficient profits.

The extent to which the profits are earned will depend on many other

things like magnitude of sales

Sales are necessary to earn profits.

But sales do not convert into cast instently, there is a time lag btwn sale

of goods and receipt of cash, so therefore there is a need for WC in the

form of CA to deal with this problem and to sustain the sales activity.

This is referred to as operating or cash cycle

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the continuing flow of cash to suppliers, to inventory, to account

receivables, and back into cash is called as operating cycle.

its the length of time necessary to

complete the following cycle of events

Namely..

Conversion of cash into inventory

Conversion of inventory into receivables

Conversion of receivables into cash

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cash

inventory

Receivables

Phase 1

Phase 2

Phase 3


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OPERATING CYCLE

DEFINITION

The average time between purchasing oracquiring inventory and receivingcash

proceeds from its sale.

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Cash and Operating Cycle Operating cycle and cash cycle are two important components of working

capital management. Together they determine the efficiency of a firmregarding working capital management.

Operating cycle refers to the delay between the buying of raw materials andthe receipt of cash from sales proceeds. In other words, operating cyclerefers to the number of days taken for the conversion of cash to inventorythrough the conversion of accounts receivable to cash. It indicates towards

the time period for which cash is engaged in inventory and accountsreceivable. If an operating cycle is long, then there is lower accessibility tocash for satisfying liabilities for the short term.

Operating cycle takes into consideration the following elements: accountspayable, cash, accounts receivable, and inventory replacement.

The following formula is used for calculating operating cycle:

Operating cycle = age of inventory + collection period

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Cash cycle is also termed as net operating cycle, asset conversion cycle,working capital cycle or cash conversion cycle. Cash cycle is implemented inthe financial assessment of a commercial enterprise. The more the figure is

increased, the higher is the period for which the cash of a commercial entityis engaged in commercial activities and is inaccessible for other functions,for instance investments. The cash cycle is interpreted as the number ofdays between the payment for inputs and getting cash by sales ofcommodities manufactured from that input.

The fundamental formula that is applied for the calculation of cashconversion cycle is as follows:

Cash cycle = (Average Stockholding Period) + (Average ReceivablesProcessing Period) - (Average Payables Processing Period)

Average Receivables Processing Period (in days) = AccountsReceivable/Average Daily Credit Sales Average Stockholding Period (indays) = Closing Stock/Average Daily Purchases Average Payable

Processing Period (in days) = Accounts Payable/Average Daily CreditPurchases

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A short cash cycle reflects sound management of working capital. On the otherhand, a long cash cycle denotes that capital is occupied when the commercial

entity is expecting its clients to make payments.

There is always a probability that a commercial enterprise can face negative cashconversion cycle, in which case they are getting payments from the clients beforeany payment is made to the suppliers. Instances of such business entities arecommonly those companies, which apply JIT or Just in Time techniques, forexample Dell, as well as commercial enterprises, which purchase on terms andconditions of longer duration credits and perform sales against cash, for instance

Tesco.

The more the manufacturing procedure is extended, the higher the amount of cashshould be kept engaged in inventories by the company. Likewise, the more time istaken for the clients for the purpose of bill payment, the more is the accountsreceivable amount. From another viewpoint, if a company is able to detain thepayment for its internal inputs, it can decrease the amount of money required. Putdifferently, the net working capital is diminished by accounts payable.

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Sources of Working Capital

FinanceSources for Financing Working Capital (i) Permanent or Fixed (ii) Temporary or variable

Long Term Sources: 1.Shares 2.Debentures

3.Public deposits 4.Ploughing back of profits 5.Loans from Financial Institutions

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Short term sources

Trade credit Bank credit-

Cash ODsCash credits

Loans

Bills purchased/discounted

Term loans for working capital

Letter of credit

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Shares-the total capital of the company will divided

into equal number of units called as shares and will

be offered for public subscription

Debentures-its an acknowledgement of debt. these

are long term debt instrument used by business

firms to raise a large sum of money.

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Trade credit- it refers to the credit extended by the supplier

of goods and services in the normal course of business.Cash is not paid immediately for the purchase but aft an

agreed period of time thus trade credit represents a sourse of

finance for credit purchase.

There is no formal negotiation for trade credit its just an

informal agreement btwn the buyer and the seller.

Cash discount- it implies a percentage deduction from the

purchase price, if the buyer pays within a specified time that

is shorter than the credit period.cash discount is for prompt payment.

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Bank credit Overdraft-its the facility extended to current account holders where in the

customers are allowed to draw cash more than the balance in his account. so

therefore the interest charged is high.

Loans-here the entire amount of borrowings is credited to the loan account of the

borrower. The borrower has to pay interest on the total amount and the loans are

repayable on demand or in periodic installments

Bills discounted-here the seller of the goods draws the bill on the purchaser of the

goods, payable on demand or aft a period not exceeding 90 days. on acceptance of

the bill, the seller offers it to the bank for discount or purchase on discounting the

bank releases the fund to the seller.

term loans-under this arrangement, banks advance loans for 3-7 years repayable

in yearly or half yearly installment

Letter of credit-its a letter written by a bank stating that the bank guarantees

payment of an invoiced amount if all the under laying agreements are met.

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Mode of security

Banks provide credit on the basis of the following mode of security

Hypothecation

Pledge

Lien

Mortgage

Charge

Certificate of deposits

Commercial Papers

Factoring

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Hypothecation-the bank provides credit to the borrower against the security of

movable property, usually inventory of goods. The goods hypothecated

continue to be in the possession of the owner of these goods but the bank has

the legal rights to sell the goods to realise the outstanding amount.

Pledge-here the goods offered as security are transferred to the physical

possession of the lender of money. the goods are in the custody of the bank the

borrower who offers the security is called pledger while the bank is called as

pledgee. The bank must take reasonable care of the pledged goods and in case

of non payment of the loan the bank enjoys the right to sell the goods.

Lien-it refers to the right of a party to retain goods belonging to another partyuntil a debt to him is paid. Particular lein is a right to retain goods until a claim

pertaining to these goods is fully paid.

and general lien can be applied until all dues are paid.

Mortgage-it is the transfer of a legal interest in specific immovable property for

securing the payment of debt the mortgage interest in the property is

terminated as soon as the debt is paid.mortagage is an additional security forWC credit by banks.

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Charge-a charge is not the transfer of interest in the immovable property though

it is a security for payment of money to another.its created by the act of parties

or by the operation of law.

Commercial papers-its an unsecured negotiable instrument its a form offinancing consisting of short term unsecured promissory notes issued by a firm

with high credit rating for fixed maturity period. the issuer promises the buyer a

fixed amt at a future period but pledges no asset his liquidity and earnings are

the only guarantee.

Certificate of deposits-CDs are a marketable receipt of funds deposited in a

bank for a fixed period at a specific rate of interest. before the period expiresthe depositor cannot encash from his banker but he can sell it in secondary

market. therefore the instrument has liquidity and is easily marketable.

Factoring-factoring involves sale of account receivables to a factor who charges

a commission( he is a middle man), here the factor bears the credit risk

associated with the accounts receivable purchased by it and provides funds in

advance of collection and thus, finances receivables

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Thank you

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Working Capital Managemnt Module 1 Afm

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