CHAPTER NO 5 WORKING CAPITAL MANAGEMENT FINANCE WORKING

CHAPTER NO. 5 WORKING CAPITAL MANAGEMENT & FINANCE

WORKING CAPITAL MANAGEMENT Capital required for a business can be classified under two categories VIZ. , (1) Fixed capital (2) Working capital Investments in the long term assets represent that part of firm’s capital which is blocked on a permanent of fixed basis is called fixed capital Funds also needed for short term purposes for the purchase of raw materials, payments of wages etc are known as working capital. “ Working capital is the amount of funds necessary to cover the cost of operating the enterprises” SHUBIN

CONCEPTS OF WORKING CAPITAL BALANCE SHEET CONCEPT GROSS WORKING CAPITAL- it refers to that amount of capital which is invested only in current assets of the firm. NET WORKING CAPITAL = Current assets – current assets NWC may be negative or positive. OPERATING CYCLE OR CIRCULAR FLOW CONCEPT Investment in current assets keep revolving fast & are being constantly converted in to cash & this cash flows out again in exchange for other current assets known as revolving or circulating capital.

GROSS WORKING CAPITAL Total Current assets Where Current assets are the assets that can be converted into cash with in an accounting year & include cash , debtors etc. Referred as “Economics Concept” since assets are employed to derive a rate of return. FEARTURES OF CURREN ASSETS v Short Life Span cash balances may be held idle for a week or two , thus a/c may have a life span of 30 -60 days etc. v Swift Transformation into other Asset forms each CA is swiftly transformed into other asset forms like cash is used for acquiring raw materials , raw materials are transformed into finished goods and these sold on credit are convertible into cash

NET WORKING CAPITAL Current Assets – Current Liabilities Referred as ‘point of view of an Accountant’. ü It indicates liquidity position of a firm & suggests the extent to which working capital needs may be financed by permanent sources of funds. ü It indicates the margin of protection available to the short term creditors ü It indicates the financial soundness of the firm

CONSTITUENTS OF CURRENT ASSETS & LIABLITIES CURRENT ASSETS CASH IN HAND Ø BILLS RECEIVABLE Ø SUNDRY DEBTORS Ø SHORT TERM LOANS & ADVANCES Ø TEMPORARY INVESTMENTS OF SURPLUS FUNDS Ø PREPAID EXPENSES Ø ACCRUED INCOMES Ø INVENTORIES OF STOCK (1) RAW MATERIAL (2) WORK-IN-PROCESS (3) STORES & SPARES (4) FINISHED GOODS Ø v v v v CURRENT LIABLITIES BILLS PAYABLE SUNDRY CREDITORS OUTSTANDING EXPENSES SHORT TERM LOANS , ADVANCES& DEPOSISTS DIVIDEND PAYABLE BANK OVERDRAFT PROVISION FOR TAXATION

OPERATING CYCLE OR CIRCULAR FLOW CONCEPT 1. Cash received from debtors & paid to suppliers of raw material 4. Sale of finished goods Operating cycle 3. Finished goods produced 2. Raw material introduced in to process

OPERATING CYCLE OR CIRCULAR FLOW CONCEPT 1. Gross operating cycle 2. Net operating cycle Raw material conversion period Receivable conversion period Gross operating cycle is the sum total of these 4 Finished goods conversion period Work in process conversion period Net operating cycle period = Gross operating cycle period - Payable deferral period

OPERATING CYCLE Purchase Resources Pay Sell on Credit Receive Cash Inventory Conversion Receivables Conversion Payables Period Cash Conversion Cycle Operating Cycle 9

FORMULA TO DETERMINE NET OPERATING CYCLE PERIOD 1.

CLASSIFIACATION OR KINDS OF WORKING CAPITAL ON THE BASIS OF CONCEPT GROSS WORKING CAPITAL NET WORKING CAPITAL KINDS OF WORKING CAPITAL PERMANENT OR FIXED WORKING CAPITAL ON THE BASIS OF TIME TEMPORARY OR VARIABLE WORKING CAPITAL REGULAR WORKING CAPITAL RESERVE WORKING CAPITAL SEASONAL WORKING CAPITAL SPECIAL WORKING CAPITAL

THE NEEDS OR OBJECTS OF WORKING CAPITAL For the purchase of raw materials, components & spares q To pay wages & salaries q To incur day to day expenses & overheads costs q To meet selling costs q To provide credit facilities to the customers q To maintain the inventories of raw material, work-in-process, stores and spares & finished goods. As profits earned depend upon magnitude of sales and they do not convert into cash instantly, thus there is a need for working capital in the form of CA so as to deal with the problem arising from lack of immediate realization of cash against goods sold. This is referred to as “Operating or Cash Cycle”. It is defined as “The continuing flow from cash to suppliers, to inventory , to accounts receivable & back into cash q

ADEQUATE WORKING CAPITAL ADVANTAGES OF ADEQUATE WORKING CAPITAL o SOLVENCY OF THE BUSINESS ADVANTAGES OF DISADVANTAGES OF INADEQUATE /EXCESSIVE WORKING CAPITAL • • o GOODWILL o EASY LOANS • o CASH DISCOUNTS • o REGULAR SUPPLY OF RAW MATERIALS • o REGULAR PAYMENTS OF SALARIES, WAGES, & OTHER DAY TO DAY COMMITMENTS o EXPLOITATION OF FAVOURABLE MARKET CONDITIONS • • • IDLE FUNDS LEADS TO UNNECESSARY BUYING HABITS DEFECTIVE CREDIT POLICY CREATES OVERALL INEFFICIENCY RISE IN SPECULATIVE TRANSACTION DIFFICULTY IN PAYING SHORT TERM LIABLITIES DIFFICULTY IN AVAILING DISCOUNT RATE OF RETURN FALLS

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS 1. Nature & character of business 2. Size of business/ scale of operation 3. Production policy 4. Manufacturing process/ length of production cycle 5. Seasonal variations 6. Working capital cycle 7. Rate of stock turnover 8. Credit policy 9. Business cycle 10. Rate of growth of business 11. Earning capacity & dividend policy 12. Price level changes 13. Other factors

WORKING CAPITAL MANAGEMENT Management of working capital is concerned with the problems that arise in attempting to manage the current assets, the current liabilities & the inter-relationship that exists between them or we can say it refers to all the aspects of administration of both current assets & current liabilities. Working capital management policies of a firm have a great effect on its profitability, liquidity & structural health of the organization. In this context, working capital management is three dimensional in nature ; 1. PROFITABILITY, RISK, LIQUDITY 2. COMPOSITION & LEVEL OF CURRENT ASSETS 3. COMPOSITION & LEVEL OF CURRENT LIABLITIES 3 DIMENSION OF WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT Decisions relating to working capital and short term financing are referred to as working capital management. Short term financial management concerned with decisions regarding to CA and CL. Management of Working capital refers to management of CA as well as CL. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. Active working capital management is an extremely effective way to increase enterprise value. Optimizing working capital results in a rapid release of liquid resources and contributes to an improvement in free cash flow and to a permanent reduction in inventory and capital costs, thereby increasing liquidity for strategic investment and debt reduction. Process optimization then helps increase profitability.

GOALS OF WORKING CAPITAL MANAGEMENT v The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Businesses face ever increasing pressure on costs and financing requirements as a result of intensified competition on globalised markets. When trying to attain greater efficiency, it is important not to focus exclusively on income and expense items, but to also take into account the capital structure, whose improvement can free up valuable financial resources Investment in CA represents a substantial portion of total investment. Investment in CA and level of CL have to be geared quickly to changes in sales.

PRINCIPLES OF WORKING CAPITAL MANAGEMENT POLICY PRINCIPLE OF RISK VARIATION v PRINCIPLE OF COST OF CAPITAL v PRINCIPLE OF EQUITY POSITION v PRINCIPLE OF MATURITY OF PAYMENTS v METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS PERCENTAGE OF SALES METHOD REGGRESSION ANALYSIS METHOD CASH FORECASTING METHOD OPERATING CYCLE METHOD PROJECTED BALANCE SHEET METHOD

FACTORS REQUIRING CONSIDERATION WHILE ESTIMATING WORKING CAPITAL 1. Total cost incurred on material, wages, & overheads 2. The length of time for which raw materials are to remain in stores before they are issued 3. The length of the production cycle or work in process 4. The length of sales cycle during which finished goods are to be kept waiting for sales 5. The average period of credit allowed to customers. 6. The amount of cash required to pay day to day expenses of the business 7. The average amount of cash required to make advance payments 8. The average cerdit period expected to be allowed by suppliers. 9. Time lag in the payments of wages & other expenses.

INVESTMENT DECISION PROCESS 20

FINANCING OF WORKING CAPITAL a. Financing of permanent/fixed/l ong term working capital b. Financing of temporary, variable or short term working capital 1. Commercial 1 2. . SHARES 2. Indigenous bankers 3. Trade DEBENTURES 4. 3. PUBLIC DEPOSITS banks creditors Installment credits Accounts receivable 5. 4. Ploughing back of profits 6. 5. Loans from financial institutions Accrued expenses 7. Commercial papers 8. advances 9. Commercial banks

WORKING CAPITAL MANAGEMENT DETERMINING THE WORKING CAPITAL FINANCING MIX/ APPROACHES TO FINANCING MIX NEW TRENDS IN FINANCING WORKING CAPITAL BY BANKS 1. DEHEJIA COMMITTEE THE HEDGING OR MATCHIN G APPROAC H THE CONSERVATIVE APPROACH THE AGGRESSIVE APPROACH 6 CO. KAN MM NA ITT N EE TY 5. AR E V RA ITTE K A M CH OM C RE E O CH TE 2. MMI CO 3 CO. TAN MM DO ITT N EE 4. MARATHE COMMITTE E

WORKING CAPITAL ANALYSIS OR NEASURING THE WORKING CAPITAL (A) RATIO ANALYSIS 1. CURRENT RATIO 2. ACID TEST RATIO 3. ABSOLUTE LIQUID RATIO 4. INVENTORY TURNOVER RATIO 5. RECEIVABLE TURNOVER RATIO 6. PAYABLES TURNOVER RATIO 7. WORKING CAPITAL TURN OVER RATIO 8. RATIO OF CURRENT LIABLITIES TO TANGIBLE NET WORTH (B) FUNDS FLOW ANALYSIS 1. CASH FLOW ANALYSIS 2, FUND FLOW ANALYSIS (C) WORKING CAPITAL BUDGET 1. LONG TERM WORKING CAPITAL BUDGET 2. SHOT TERM WORKING CAPITAL BUDGET

THE FINANCING DECISION PROCESS Monitor cash flow forecasts annually / quarterly / monthly / weekly / daily Identify deficits Determine: Amount / currency Duration / location Internal policy covering Borrowing internally Instruments Financing policy Existing limits Performance objectives Existing facilities Balance sheet/ratio impact Tax External Factors: FINANCING DECISION Financing action Documentation Recording / monitoring / reporting Liquidation Interest rates / trends Currency exchange rates Economic factors Liquidity of market

ZERO WORKING CAPITAL APPROACH When, total of current assets = total of current liabilities then working capital requirement will be equal to zero. such a situation maybe called as zero working capital situation. Total of current assets – total of current liabilities = zero ZWC approach, which aims at saving in opportunity cost of funds invested in current assets & ensuring a smooth & uninterrupted working capital cycle, is a recent technique of working capital management.

THANK YOU