WORKING

CAPITAL

Working capital Introduction

Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities.These items are also referred to as circulating capital Corporate executives devote a considerable amount of attention to the management of working capital.

Definition of Working Capital

Working Capital refers to that part of the firm’s capital which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Find thus invested , in current assets keep revolving fast and are constantly converted into cash and this cash flow out again and exchange for other current assets. Working Capital also known as revolving or circulating capital or short term capital.

Components of Working CapitalThe Working Capital cycle is made up of four core components: Cash & cash equivalent Creditors / accounts payable Inventory / stock in hand Debtors / accounts receivables

Types of working capital needs The working capital need can be bifurcated into permanent working capital

and temporary working capital.

Permanent working capital- There is always a minimum level of working capital which is continuously required by a firm in order to maintain its activities like cash, stock and other current assets in order to meet its business requirements irrespective of the level of operation.

Temporary working capital- Over and above the permanent working capital, the firm may also require addition working capital in order to meet the requirements arising out if fluctuations in sales volume. This extra working capital needed to support the increased volume of sales is known as temporary or fluctuating working capital.

Determination of Working Capital Requirements

General nature of business Production cycle Business cycle fluctuation Credit policy Growth and expansion Profit level Level of taxes Dividend policy Depreciation policy Price level changes Operating efficiency

THE NEED FOR WORKING CAPITALWorking capital is required for the following purposes:

1. Replenishment of Inventory- A sufficient stock of inventory is required to support the sales target of the firm. This requirement, however, will depend on the availability of resources. An unserved portion of demand may mean lost revenues for the firm.2. Provision for Operating Expenses- To maintain the operations of the firm on a day- to- day basis, a working capital is required. This will be needed to take care of salaries and wages, advertising, taxes and licenses, insurance premium, and interest payments.

3. Support for Credits Sales- At times, conditions require that credit sales be extended to the

firm’s clients. This will need sufficient working capital to enable the firm to maintain its operations until receivables are converted into cash.

4. Provision of a Safety Margin- The firm should have sufficient amount of capital to provide for

unexpected expenditures, delays in the expected inflow of cash, and possible decline in revenue.

Cash Requirements- The firm needs cash to pay for expenditures that arise from time to time. Even if the anticipated cash receipts is equal to the anticipated cash expenditures, it is still necessary to maintain a sufficient cash fund for the firm to meet its cash commitments. It is, therefore, requiredthat a positive cash balance be maintained so that the firm’s obligations are settled they become due.

The amount of cash needed depends upon the following:1. The amount of the firm’s purchases and cash sales;2. The time period for which the firm receives and grants credit;3. The time period from the dates of purchase of raw materials and

payment of wages to the dates of cash receipts from sales;4. The amount of cash to be used for investment in inventories; and 5. The amount of cash needed for other purposes such as cash

dividends.

Accounts Receivable Requirements- Since liquidity is a primary concern of sound business finance, firms prefer cash sales over credit sales. Many companies, however, cannot avoid the extension of credit to customer for various reasons. Credit is used to sustain and to promote

production, distribution, and consumption of goods and services.

Inventory Requirements- The production of large stocks of inventory generate savings as a result of lower production cost. It will also provide the firm with large quantity of stocks to meet increasing or unusually large orders from customers. The maintenance of large

stocks of inventory, however, may unnecessarily tie up funds which could have been made available for other uses. Outside financing may even be required. In addition, storage and warehousing costs may also increase.

MANAGEMENT OF WORKING CAPITAL Working capital must always be able to cover fund requirements of the company as they are needed. The are times when unusual pressures on working capital makes the job of the finance manager

very. To overcome this, a system should be adopted considering the following objectives:

1. Working capital must be adequate to cover all current financial requirements. The quantity of inventory stocks to be carried and the

maximum allowable amount of receivables must be decided in advance.2. The working capital structure must be liquid enough to meet current obligations as they fall due. Salaries and wages must be paid on time. Raw

materials and supplies must be acquired on days they are needed.3. Working capital must be conserved through proper allocation and

economical use.4. Working capital must be used in attainment of the profit objectives of the firm.

LIQUIDITY MANAGEMENT Liquidity refers to the ability of the firm to pay its bills on time or otherwise meet its current obligations. Activities geared towards achieving the liquidity management.The objective of management is to acquire sufficient amounts of funds to cover the cash requirements of the firm. The cash inflows of the firm come from various sources which are briefly described as follows.

1. Cash Sales - The percentages of cash derived from sales vary from company to company and from

industry to industry.2. Collection of Accounts Receivables- The credit policies and the pattern of company sales determine the frequency and volume of collections form receivables.3. Loans- Loans from banks and other creditors may be availed of by management mostly on its own initiative.

LIQUIDITY MANAGEMENT cont’dThe timing and amount of cash receipts derived from loans depend largely on the borrowing firm.

4. Sale of Assets-Assets are sometimes sold by the company for various reasons. Obsolescence is one of those.5. Ownership Contribution- Additional contribution from the owners are sometimes tapped to

improve the liquidity posture of the firm.6. Advances from Customers- Manufacturers, at times, require cash advances from customers soon as an order is made and before production is started.

Cash Management- Idle cash earns nothing and even if it is kept in a bank, the interest it earns in

minimal. If sufficient amounts of profit must be attained, cash should be invested. Sufficient cash must be maintained, however, to cover the firm’s cash expenditures. The activity involved in achieving these two opposite goals is called cash management. Money Mobilization

- Some companies maintain branches and agencies in distant places. Those that serve customers directly may find that they are also serving customers from far- flung areas.

Improved Cash Flow Forecasting- A cash flow forecast with a high degree of precision and reliability provides the firm with realistic approaches to planning and budgeting. The disadvantages of cash excess and cash shortages are eliminated if not minimized.

Improved Cash Flow Forecasting cont’dThe advantages brought by an improved cash flow forecast are the following:1. Surplus funds are more fully invested;2. Alternative methods of meeting the outflows can be explored; and3. The creation of special reserves for major future outlays will be

minimized. Defining and Quantifying the Liquidity Reserve Needs of the Firm.- Firms are faced with a number of uncertainties and contingencies which may require cash reserves. To be protected against the worst possibilities, a very large reserve of cash will be needed. The idea is to avoid unnecessary losses or expenditures brought about by liquidity problems. Several steps are:

1. Identification of contingencies requiring protection;2. Assessment of the probabilities of the contingencies occurring;3. Assessment of the probabilities of the contingencies occurring at the same

time; and

cont’d Assessment of the probable amount of cash required if each of the contingencies happens.

To illustrate, assume that a labor strike happening in the premises of the company will paralyze operations. Borrowing funds to cover the necessary expenditures of the firm will penalize the firm with interest charges amounting to one million pesos. It has also been ascertained that if a reserve fund has to be carried for the contingency, the firm will be penalized with eight thousand pesos in the form of lost income which could have been otherwise earned by the idle cash reserve.

If the probability of the strike happening is placed at 50%, the expected value of the options may be computed as follows:

Carrying a cash reserve in this case is more economical to the firm because it carries a lower penalty expected value. Development of Alternative Sources of Liquidity

- Once the liquidity reserve needs of the firm have been defined and quantified, alternative sources of meeting these needs should be identified and evaluated.

One possible alternative is the exploitation of the unused borrowing capacity of the firm.

OPTION PENALTY PROBABILITY EXPECTEDNo reserve 1,000,000 50% 500,000

With cash reserve 800,000 50% 400,000

Search for More Productive Uses of Cash Surplus- Cash surplus may be utilized by the firm to earn higher returns. A gap may exist , however, between the time when cash starts coming in and the time it is actually made more productive. As various planning activities must also be geared towards eliminating the unproductive or less productive gap.- In as much as new investment opportunities may be made available from time to time, a

continuous search and evaluation activity must be done. Accounts Receivable Management

- As sales on account be avoided most of the time, management must face the difficulty squarely and make it work to the advantage of the firm. This is

important because when accounts receivables are not properly managed, the financial viability of the firm may be impaired.

Objectives. One of the goals of business finance is to maximize profitability. In this regard, all activities of the firm, more credit is extended. Increased sales, however, is not an end in itself. The objective of accounts receivable management is to determine the cost and profitability of credit sales. The second objective accounts receivable management is the projection of cash flows from receivable.

Elements of the cost of Credit- The cost of credit is composed of three elements: (1) bad debts costs; (2) cost of invested funds; and (3) administrative costs.

Bad debts cost refers to accounts receivable uncollected and subsequently written off. The cost of invested funds refers to the rate at which the firm could borrow funds to finance credit sales. Theseinclude form letters, individually written letters, telephone charges, clerical and administrative time spent on an account, and credit and investigation expenses. Functions of the Credit Department

- The credit department performs the following functions:1. gathering and organizing of information necessary for decisions on the granting of credit to particular customers; 2. assuring that efforts are made to collect receivables when they become due; and 3. determining and carrying out appropriate efforts to collect accounts of customers who cannot or do not intend to pay.

Sources of Credit Information- A variety of sources may be used to obtain credit information concerning

customers. The sources most commonly used are the following:1. personal interviews;2. references;3. credit bureaus;4. credit-reporting agencies; and5. banks

-Personal interviews provide basic information concerning an applicant for credit. The applicant is usually required to fill up a credit application blank. The credit application the following items:

1. the name of the applicant;2. residence and former address;3. occupation or business4. business address5. bank where applicant maintains an account; and6. Property owned

CONT’D

Credit bureaus are institutions organized for the exchange of ledger information among associated creditors. 1. reports 2. bulletins; 3. credit guides; and 4. special services.

Evaluation of Credit Risk- Before credit is granted, the risk involved is evaluated. This is done after information regarding

the credit risk has been gathered. In the evaluation of a credit risk, the basic criteria used to refer the following:

1. Capital;2. Capacity;3. Character; and4.Conditions5. Collateral

Capital refers to the financial resources of the credit applicant. The balance sheet is a very useful tool in determining the resources of the applicant.Capacity refers to the ability of the applicant to operate successfully. Character refers to the reputation for honesty and fair dealing of the applicant or the owners of the firm applying for credit. Conditions refer to the environment required for the extension of credit.

Inventory Management refers to the activity that keeps track of how many of the procured items needed to create a product or service are on hand, where items is , and who has responsibility for each item.

A successful inventory management program’s main objective is to strike a balance among three key elements as follows:

1. Customer service2.Inventory investment3. Profit

Customer Service- the period between when the order is made and the date of delivery is very

important to the customer. Shorter periods are preferred.Inventory Investment- funds tied up in inventory should ideally be kept to a minimum without sacrificing customer service. These usually take the form of interests, insurance, taxes, obsolescence, and storage.

Profit-the level of inventory carried by the company most often affects the profitability of the company. The task of the management is to determine the level of which would bring the highest return of equity.

Functions of Inventory- Inventories perform certain functions. These are the following:1. they serve to offset errors contained in the forecast of the demand for the company’s products.2. they often permit more economical utilization of equipment, buildings, and manpower when the nature of the business is such that fluctuations in demand exists; and

Cont’d

3. it permits the company to purchase or manufacture in economic lot sizes.

Forms of Inventory 1.Raw materials

2. Work-in-process; and 3. Finished goods.

LIQUIDITY MANAGEMENT

Accounts Receivable Management

Cash ManagementInventory Management

Money Mobilization

Effective Cash Flow Forecasting

Liquidity Reserve Definition and Quantification

Productive Use of Surplus Assets

Determine Cost and Profitability of Credit Sales

Projection of Cash Flows from Receivables

Direction and Control of Credit

Extension

Customer Service

Inventory Investment

Profit Aspects

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