WORKING CAPITAL MGMT.

Working capital in the most ordinary form of business

communication means -- that part of the capital which is used for running the day to day business activities of a

company.

The working capital of a company can be divided in two parts.

GROSS WORKING CAPITAL NET WORKING CAPITAL

Gross W.C. – It refers to the sum of the firms investment in current assets.

Current assets – Those assets which can be converted into cash within an accounting year.

Eg. Cash, Short term securities, Debtors, Stock etc.

Net Working Capital – The difference between the Gross working capital and the total of current liabilities.

Current liabilities – Claims of outsiders and insiders which are to be paid within one accounting year. Eg.Creditors, Bills payable, Outstanding expenses etc.

Hence Net working capital can be +ive or –ive.

INVESTMENT IN CURRENT ASSETS

HOW MUCH ? EXECESSIVE OR INADEQUATE ARE THE

TWO DANGER SIGNALS.

SHOULD BE JUST ADEQUATE NOT MORE AND NOT LESS.

EXCESSIVE INVESTMENT IN CURRENT ASSETS.

REDUCES PROFITABILITY. IDLE INVESTMENT EARNS NOTHING.(EXCESS

CASH) RAISES PROBABILITY OF LOSS – DEBTORS,

STOCK ETC.

INADEQUATE OR LESSER INVESTMENT IN WORKING CAPITAL.

CANNOT MEET CURRENT OBLIGATIONS. EARNS A BAD NAME. REDUCES CONFIDENCE OF THE

STAKEHOLDERS. EVEN THE SOLVENCY MAY BE THREATENED.

THE NEED OF WORKING CAPITAL OF A FIRM MAY FLUCTUATE WITH THE AMOUNT OF BUSINESS ACTIVITY.

THIS MAY CAUSE AN “EXCESS” OR “SHORTAGE” FREQUENTLY.

PROMPT ACTION BY THE MANAGERS TO CORRECT IMBALANCES IS A PART OF WORKING CAPITAL MGMT.

When, there is shortage of funds or working capital due to any reason the manager must quickly be able to arrange such finance.

Similarly, in case of excess funds they should not be kept lying idle, but should be invested properly.(Where ?)

Thus the manager should be conversant with the sources as well as the investment avenues.

NET WORKING CAPITAL is a qualitative concept.

It tells us about the LIQUIDITY position of a company.

If the Net W.C. is negative (CL is more than the CA) the goodwill/brand/image of the company may be tarnished both from within and outside business world.

The current assets should always be more than the current liabilities.

OPERATING CYCLE Acquisition of resources & raw materials. Manufacturing process Sales (Cash / Credit) Collection. TOTAL TIME TAKEN IN THE ABOVE IS

CALLED THE OPERATING CYCLE.THUMB RULE : HIGHER THE OPERATING CYCLE

MORE THE REQIREMENT OF WORKING CAPITAL.

Cash inflows are very uncertain. Cash outflows are very certain.

Hence, maintenance of exact working capital is almost impossible.

For safety purpose maintaining liquidity of working capital is essential.(In the form of cash, stock of raw materials and fg’s)

Calculation of operating cycle(time) RAW MATERIAL CONVERSION PERIOD+WIP CONVERSION PERIOD+FINISHED GOODS CONVERSION PERIOD__________________________________=INVENTORY CONVERSION PERIOD+DEBTORS CONVERSION PERIOD_________________________________=OPERATING CYCLE =

OPERATING CYCLE.xlsx

PERMANENT & VARIABLE W.C. The amount of working capital required

keeps on changing from time to time.

Hence, a fixed amount of working capital or a minimum amount of working capital is always maintained called the permanent working capital.

Over and above the minimum working capital fresh working capital is replenished as per requirement.

For example extra inventory of finished goods & raw materials may be kept during the peak periods of sale. Investment in receivables and debtors may also increase during such period.

HENCE, THE EXTRA WORKING CAPITAL NEEDED, OVER AND ABOVE THE MINIMUM LEVEL, IN ORDER TO SUPPORT THE CHANGING PRODUCTION AND SALES ACTIVITIES IS CALLED THE VARIABLE WORKING CAPITAL.

Consequenses of excess working capital Accumulation of inventories ->

mishandling, waste, theft, spoilage etc. High incidence of bad debts -> defective

credit policy and slack collection period. Makes the management complacent -

>managerial inefficiency. Accumulation of excess inventory gives

rise to the tendency of speculative profits -> liberal dividend policy -> difficult days ahead.

Stagnates growth -> cannot take up new projects and ventures as funds are blocked in either stock or receivables.

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

The firm looses its goodwill -> not being in a position to honour its short term obligations.

DETERMINANTS OF WORKING CAPITAL(FACTORS) NATURE OF BUSINESS :

Trading houses : Less investment in fixed assets and more investment in current assets.Financial houses : Less investment in fixed assets and more investment in current assets.

Retail shops : Less investment in fixed assets and more investment in current assets.

SAME IS THE CASE WITH MANUFACTURES OF TOBACO AND MEDIUM SIZED CONSTRUCTION HOUSES.

On the other hand big manufacturing houses of steel, cement and other public utilities require lessor current assets as compared to their requirement of fixed assets.

SALES & DEMAND CONDITIONS :

Sales depend on demand conditions. Many firms experience the seasonal and cyclical fluctuations in the demand for their products.Such variations in demand and consequently sales effect the requirement of working capital of the firm specially the variable part. Eg. Raincoat, Sunglass,Icecream etc.

NATURE OF PRODUCT & MANUFACTURING

POLICY :

The operating cycle required for a boiler or a hot rolling mill or an automobile may range from 06 to 24 months whereas the operating cycle required for detergent powder, soaps or chocolates may be a few days or even hours.

REMEMBER :THUMB RULE : HIGHER THE OPERATING CYCLE MORE THE REQIREMENT OF WORKING CAPITAL.

CREDIT POLICY : The credit policy decides the level and quality of debtors.

Industry norms and credit rating before offering credit are important factors to be looked into.Whom to offer credit and what terms and whom not to offer must be critically examined.

Availability of credit :

The credit terms the firm receives from its creditors also decides the amount of requirement of working capital.

A firm which can get bank credit easily will operate with less working capital than a firm without such facility.

ESTIMATING WORKING CAPITAL REQUIREMENTS

THERE ARE THREE WAYS TO DO IT.

CURRENT ASSETS HOLDING PERIOD :THIS IS ESTIMATION OF WORKING CAPITAL REQUIREMENT ON THE BASIS OF AVG. HOLDING PERIOD OF CURRENT ASSETS & RELATING THEM TO COST ON THE BASIS OF EXPERIENCE IN PREVIOUS YEARS.

ESTIMATING WORKING CAPITAL REQUIREMENTS

RATIO OF SALES :

THIS IS ESTIMATION OF WORKING CAPITAL REQUIREMENT AS A RATIO OF SALES ON THE ASSUMPTION THAT CURRENT ASSETS CHANGE WITH SALES.

ESTIMATING WORKING CAPITAL REQUIREMENTS

RATIO OF FIXED INVESTMENT :

THIS IS ESTIMATION OF WORKING CAPITAL REQUIREMENT AS A RATIO OF FIXED INVESTMENT.

LIQUIDITY VRS.PROFITABILITY If it were possible to estimate the working

capital needs exactly -- a firm would make just enough investment in working capital.

Under perfect certainity conditions the working capital would be at the minimum level.

A larger investment in current assets would mean a low ROI.

A smaller investment in current assets would mean inturruptions in production and sales.

ESTIMATING WORKING CAPITAL REQUIREMENTS

ILLUSTRATION :WORKING CAPITAL ASSESSMENT.xlsx

LIQUIDITY VRS.PROFITABILITY Let us consider the following example. Example : However, in order to increase profitability

keeping very low current assets is not always advisable.

APPROACHES TO WORKING CAPITAL CONSERVATIVE APPROACH :

The financing policy of the firm is said to be conservative when it depends more on long term funds for financing needs. Under this arrangement the firm finances its permanent assets as well as a part of its temporary current assets with long term financing.(LESS RISK OF SHORTAGE)In the periods when the firm does not require temporary current assets the idle long term funds can be invested.

APPROACHES TO WORKING CAPITAL AGGRESSIVE APPROACH :

Under this approach the firm finances a part of its permanent current assets by short term financing.

Some firms even finance a part of their fixed assets with short term financing.

VERY HIGH PROFITABILITY BUT VERY RISKY.

APPROACHES TO WORKING CAPITAL MATCHING APPROACH :

Under this approach the firm finances its fixed assets and permanent current assets with long term finance and its temporary current assets with short term finance.

REDUCES PROFITABILITY AND RISK.

RISK RETURN TRADE OFF There is always a conflict between long

term and short term financing. Short term financing is less expensive

than long term financing BUT at the same time it involves greater risk.

The choice between long term & short term requires a trade off between risk and return.

EXAMPLE : trade off.xlsx