WORKING CAPITAL MANAGEMENTINTRODUCTIONWorking capital
(abbreviated WC) is a financial metric which represents operating
liquidity available to a business, organization or other entity,
including governmental entity. Along with fixed assets such as
plant and equipment, working capital is considered a part of
operating capital. Gross working capital equals to current assets.
Working capital is calculated as current assets minus current
liabilities. If current assets are less than current liabilities,
an entity has a working capital deficiency, also called a working
capital deficit.A company can be endowed with assets and
profitability but short of liquidity if its assets cannot readily
be converted into cash. Positive working capital is required to
ensure that a firm is able to continue its operations and that it
has sufficient funds to satisfy both maturing short-term debt and
upcoming operational expenses. The management of working capital
involves managing inventories, accounts receivable and payable, and
cash.Working capital is the difference between the current assets
and the current liabilities. It is the amount invested by the
promoters on the current assets of the organisation.The basic
calculation of the working capital is done on the basis of the
gross current assets of the firm.working capital = current assets -
current liabilitiesWorking capital managementDecisions relating to
working capital and short term financing are referred to as working
capital management. These involve managing the relationship between
a firm's short-term assets and its short-term liabilities. 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.A managerial accounting strategy focusing on maintaining
efficient levels of both components of working capital, current
assets and current liabilities, in respect to each other. Working
capital management ensures a company has sufficient cash flow in
order to meet its short-term debt obligations and operating
expenses.Decision criteriaBy definition, working capital management
entails short-term decisionsgenerally, relating to the next
one-year periodwhich are "reversible". These decisions are
therefore not taken on the same basis as capital-investment
decisions (NPV or related, as above); rather, they will be based on
cash flows, or profitability, or both. One measure of cash flow is
provided by the cash conversion cyclethe net number of days from
the outlay of cash for raw material to receiving payment from the
customer. As a management tool, this metric makes explicit the
inter-relatedness of decisions relating to inventories, accounts
receivable and payable, and cash. Because this number effectively
corresponds to the time that the firm's cash is tied up in
operations and unavailable for other activities, management
generally aims at a low net count. In this context, the most useful
measure of profitability is return on capital (ROC). The result is
shown as a percentage, determined by dividing relevant income for
the 12 months by capital employed; return on equity (ROE) shows
this result for the firm's shareholders. Firm value is enhanced
when, and if, the return on capital, which results from
working-capital management, exceeds the cost of capital, which
results from capital investment decisions as above. ROC measures
are therefore useful as a management tool, in that they link
short-term policy with long-term decision making. See economic
value added (EVA). Credit policy of the firm: Another factor
affecting working capital management is credit policy of the firm.
It includes buying of raw material and selling of finished goods
either in cash or on credit. This affects the cash conversion
cycle.Guided by the above criteria, management will use a
combination of policies and techniques for the management of
working capital. The policies aim at managing the current assets
(generally cash and cash equivalents, inventories and debtors) and
the short term financing, such that cash flows and returns are
acceptable. Cash management. Identify the cash balance which allows
for the business to meet day to day expenses, but reduces cash
holding costs. Inventory management. Identify the level of
inventory which allows for uninterrupted production but reduces the
investment in raw materialsand minimizes reordering costsand hence
increases cash flow. Besides this, the lead times in production
should be lowered to reduce Work in Process (WIP) and similarly,
the Finished Goods should be kept on as low level as possible to
avoid over productionsee Supply chain management; Just In Time
(JIT); Economic order quantity (EOQ); Economic quantity Debtors
management. Identify the appropriate credit policy, i.e. credit
terms which will attract customers, such that any impact on cash
flows and the cash conversion cycle will be offset by increased
revenue and hence Return on Capital (or vice versa); see Discounts
and allowances. Short term financing. Identify the appropriate
source of financing, given the cash conversion cycle: the inventory
is ideally financed by credit granted by the supplier; however, it
may be necessary to utilize a bank loan (or overdraft), or to
"convert debtors to cash" through "factoring".
WORKING CAPITAL - Meaning of Working CapitalCapital required for
a business can be classified under two main categories via,1) Fixed
Capital2) Working CapitalEvery business needs funds for two
purposes for its establishment and to carry out its day- to-day
operations. Long terms funds are required to create production
facilities through purchase of fixed assets such as p&m, land,
building, furniture, etc. Investments in these assets represent
that part of firms capital which is blocked on permanent or fixed
basis and is called fixed capital. Funds are also needed for
short-term purposes for the purchase of raw material, payment of
wages and other day to- day expenses etc.These funds are known as
working capital. In simple words, working capital refers to that
part of the firms capital which is required for financing short-
term or current assets such as cash, marketable securities, debtors
& inventories. Funds, thus, invested in current assts keep
revolving fast and are being constantly converted in to cash and
this cash flows out again in exchange for other current assets.
Hence, it is also known as revolving or circulating capital or
short term capital.CONCEPT OF WORKING CAPITALThere are two concepts
of working capital:1. Gross working capital2. Net working
capitalThe gross working capital is the capital invested in the
total current assets of the enterprises current assets are
thoseAssets which can convert in to cash within a short period
normally one accounting year.CONSTITUENTS OF CURRENT ASSETS1) Cash
in hand and cash at bank2) Bills receivables3) Sundry debtors4)
Short term loans and advances.5) Inventories of stock as:a. Raw
materialb. Work in processc. Stores and sparesd. Finished goods6.
Temporary investment of surplus funds.7. Prepaid expenses8. Accrued
incomes.9. Marketable securities.In a narrow sense, the term
working capital refers to the net working. Net working capital is
the excess of current assets over current liability, or, say:NET
WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES.Net working
capital can be positive or negative. When the current assets
exceeds the current liabilities are more than the current assets.
Current liabilities are those liabilities, which are intended to be
paid in the ordinary course of business within a short period of
normally one accounting year out of the current assts or the income
business.CONSTITUENTS OF CURRENT LIABILITIES1. Accrued or
outstanding expenses.2. Short term loans, advances and deposits.3.
Dividends payable.4. Bank overdraft.5. Provision for taxation , if
it does not amt. to app. Of profit.6. Bills payable.7. Sundry
creditors.The gross working capital concept is financial or going
concern concept whereas net working capital is an accounting
concept of working capital. Both the concepts have their own
merits.The gross concept is sometimes preferred to the concept of
working capital for the following reasons:1. It enables the
enterprise to provide correct amount of working capital at correct
time.2. Every management is more interested in total current assets
with which it has to operate then the source from where it is made
available.3. It take into consideration of the fact every increase
in the funds of the enterprise would increase its working
capital.4. This concept is also useful in determining the rate of
return on investments in working capital. The net working capital
concept, however, is also important for following reasons:5. It is
qualitative concept, which indicates the firms ability to meet to
its operating expenses and short-term liabilities.6. IT indicates
the margin of protection available to the short term creditors.7.
It is an indicator of the financial soundness of enterprises.8. It
suggests the need of financing a part of working capital
requirement out of the permanent sources of funds.
CLASSIFICATION OF WORKING CAPITALWorking capital may be
classified in to ways:o On the basis of concept.o On the basis of
time.On the basis of concept working capital can be classified as
gross working capital and net working capital. On the basis of
time, working capital may be classified as: Permanent or fixed
working capital. Temporary or variable working capitalPERMANENT OR
FIXED WORKING CAPITALPermanent or fixed working capital is minimum
amount which is required to ensure effective utilization of fixed
facilities and for maintaining the circulation of current assets.
Every firm has to maintain a minimum level of raw material, work-
in-process, finished goods and cash balance. This minimum level of
current assts is called permanent or fixed working capital as this
part of working is permanently blocked in current assets. As the
business grow the requirements of working capital also increases
due to increase in current assets.TEMPORARY OR VARIABLE WORKING
CAPITALTemporary or variable working capital is the amount of
working capital which is required to meet the seasonal demands and
some special exigencies. Variable working capital can further be
classified as seasonal working capital and special working capital.
The capital required to meet the seasonal need of the enterprise is
called seasonal working capital. Special working capital is that
part of working capital which is required to meet special
exigencies such as launching of extensive marketing for conducting
research, etc.Temporary working capital differs from permanent
working capital in the sense that is required for short periods and
cannot be permanently employed gainfully in the business.
IMPORTANCE OR ADVANTAGE OF ADEQUATE WORKING CAPITALi. SOLVENCY
OF THE BUSINESS: Adequate working capital helps in maintaining the
solvency of the business by providing uninterrupted of
production.ii. Goodwill: Sufficient amount of working capital
enables a firm to make prompt payments and makes and maintain the
goodwill.iii. Easy loans: Adequate working capital leads to high
solvency and credit standing can arrange loans from banks and other
on easy and favorable terms.iv. Cash Discounts: Adequate working
capital also enables a concern to avail cash discounts on the
purchases and hence reduces cost.v. Regular Supply of Raw Material:
Sufficient working capital ensures regular supply of raw material
and continuous production.vi. Regular Payment Of Salaries, Wages
And Other Day TO Day Commitments: It leads to the satisfaction of
the employees and raises the morale of its employees, increases
their efficiency, reduces wastage and costs and enhances production
and profits.vii. Exploitation Of Favorable MarketConditions: If a
firm is having adequate working capital then it can exploit the
favorable market conditions such as purchasing its requirements in
bulk when the prices are lower and holdings its inventories for
higher prices.viii. Ability To Face Crises: A concern can face the
situation during the depression.ix. Quick And Regular Return On
Investments: Sufficient working capital enables a concern to pay
quick and regular of dividends to its investors and gains
confidence of the investors and can raise more funds in future.x.
High Morale: Adequate working capital brings an environment of
securities, confidence, high morale which results in overall
efficiency in a business.EXCESS OR INADEQUATE WORKING CAPITALEvery
business concern should have adequate amount of working capital to
run its business operations. It should have neither redundant or
excess working capital nor inadequate nor shortages of working
capital. Both excess as well as short working capital positions are
bad for any business. However, it is the inadequate working capital
which is more dangerous from the point of view of the firm.
DISADVANTAGES OF REDUNDANT OR EXCESSIVE WORKING CAPITAL1.
Excessive working capital means ideal funds which earn no profit
for the firm and business cannot earn the required rate of return
on its investments.2. Redundant working capital leads to
unnecessary purchasing and accumulation of inventories.3. Excessive
working capital implies excessive debtors and defective credit
policy which causes higher incidence of bad debts.4. It may reduce
the overall efficiency of the business.5. If a firm is having
excessive working capital then the relations with banks and other
financial institution may not be maintained.6. Due to lower rate of
return n investments, the values of shares may also fall.7. The
redundant working capital gives rise to speculative
transactionsDISADVANTAGES OF INADEQUATE WORKING CAPITALEvery
business needs some amounts of working capital. The need for
working capital arises due to the time gap between production and
realization of cash from sales. There is an operating cycle
involved in sales and realization of cash. There are time gaps in
purchase of raw material and production; production and sales; and
realization of cash.Thus working capital is needed for the
following purposes: For the purpose of raw material, components and
spares. To pay wages and salaries To incur day-to-day expenses and
overload costs such as office expenses. To meet the selling costs
as packing, advertising, etc. To provide credit facilities to the
customer. To maintain the inventories of the raw material,
work-in-progress, stores and spares and finished stock.For studying
the need of working capital in a business, one has to study the
business under varying circumstances such as a new concern requires
a lot of funds to meet its initial requirements such as promotion
and formation etc. These expenses are called preliminary expenses
and are capitalized. The amount needed for working capital depends
upon the size of the company and ambitions of its promoters.
Greater the size of the business unit, generally larger will be the
requirements of the working capital.The requirement of the working
capital goes on increasing with the growth and expensing of the
business till it gains maturity. At maturity the amount of working
capital required is called normal working capital.There are others
factors also influence the need of working capital in a
business.FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS1.
NATURE OF BUSINESS: The requirements of working is very limited in
public utility undertakings such as electricity, water supply and
railways because they sale only and supply services not products,
and no funds are tied up in inventories and receivables. On the
other hand the trading and financial firms requires less investment
in fixed assets but have to invest large amt. of working capital
along with fixed investments.2. SIZE OF THE BUSINESS: Greater the
size of the business, greater is the requirement of working
capital.3. PRODUCTION POLICY: If the policy is to keep production
steady by accumulating inventories it will require higher working
capital.4. LENTH OF PRDUCTION CYCLE: The longer the manufacturing
time the raw material and other supplies have to be carried for a
longer in the process with progressive increment of labor and
service costs before the final product is obtained. So working
capital is directly proportional to the length of the manufacturing
process.5. SEASONALS VARIATIONS: Generally, during the busy season,
a firm requires larger working capital than in slack season.6.
WORKING CAPITAL CYCLE: The speed with which the working cycle
completes one cycle determines the requirements of working capital.
Longer the cycle larger is the requirement of working capital.7.
RATE OF STOCK TURNOVER: There is an inverse co-relationship between
the question of working capital and the velocity or speed with
which the sales are affected. A firm having a high rate of stock
turnover wuill needs lower amt. of working capital as compared to a
firm having a low rate of turnover.8. CREDIT POLICY: A concern that
purchases its requirements on credit and sales its product /
services on cash requires lesser amt. of working capital and
vice-versa.9. BUSINESS CYCLE: In period of boom, when the business
is prosperous, there is need for larger amt. of working capital due
to rise in sales, rise in prices, optimistic expansion of business,
etc. On the contrary in time of depression, the business contracts,
sales decline, difficulties are faced in collection from debtor and
the firm may have a large amt. of working capital.10. RATE OF
GROWTH OF BUSINESS: In faster growing concern, we shall require
large amt. of working capital.11. EARNING CAPACITY AND DIVIDEND
POLICY: Some firms have more earning capacity than other due to
quality of their products, monopoly conditions, etc. Such firms may
generate cash profits from operations and contribute to their
working capital. The dividend policy also affects the requirement
of working capital. A firm maintaining a steady high rate of cash
dividend irrespective of its profits needs working capital than the
firm that retains larger part of its profits and does not pay so
high rate of cash dividend.12. PRICE LEVEL CHANGES: Changes in the
price level also affect the working capital requirements. Generally
rise in prices leads to increase in working capital.Others FACTORS:
These are: Operating efficiency. Management ability. Irregularities
of supply. Import policy. Asset structure. Importance of labor.
Banking facilities, etc.MANAGEMENT OF WORKING CAPITALManagement of
working capital is concerned with the problem that arises in
attempting to manage the current assets, current liabilities. The
basic goal of working capital management is to manage the current
assets and current liabilities of a firm in such a way that a
satisfactory level of working capital is maintained, i.e. it is
neither adequate nor excessive as both the situations are bad for
any firm. There should be no shortage of funds and also no working
capital should be ideal. WORKING CAPITAL MANAGEMENT POLICES of a
firm has a great on its probability, liquidity and structural
health of the organization. So working capital management is three
dimensional in nature as1. It concerned with the formulation of
policies with regard to profitability, liquidity and risk.2. It is
concerned with the decision about the composition and level of
current assets.3. It is concerned with the decision about the
composition and level of current liabilities. WORKING CAPITAL
ANALYSISAs we know working capital is the life blood and the centre
of a business. Adequate amount of working capital is very much
essential for the smooth running of the business. And the most
important part is the efficient management of working capital in
right time. The liquidity position of the firm is totally effected
by the management of working capital. So, a study of changes in the
uses and sources of working capital is necessary to evaluate the
efficiency with which the working capital is employed in a
business. This involves the need of working capital analysis.The
analysis of working capital can be conducted through a number of
devices, such as:1. Ratio analysis.2. Fund flow analysis.3.
Budgeting.1. RATIO ANALYSISA ratio is a simple arithmetical
expression one number to another. The technique of ratio analysis
can be employed for measuring short-term liquidity or working
capital position of a firm. The following ratios can be calculated
for these purposes:1. Current ratio.2. Quick ratio3. Absolute
liquid ratio4. Inventory turnover.5. Receivables turnover.6.
Payable turnover ratio.7. Working capital turnover ratio.8. Working
capital leverage9. Ratio of current liabilities to tangible net
worth.2. FUND FLOW ANALYSISFund flow analysis is a technical device
designated to the study the source from which additional funds were
derived and the use to which these sources were put. The fund flow
analysis consists of:a) Preparing schedule of changes of working
capitalb) Statement of sources and application of funds.It is an
effective management tool to study the changes in financial
position (working capital) business enterprise between beginning
and ending of the financial dates.3. WORKING CAPITAL BUDGETA budget
is a financial and / or quantitative expression of business plans
and polices to be pursued in the future period time. Working
capital budget as a part of the total budge ting process of a
business is prepared estimating future long term and short term
working capital needs and sources to finance them, and then
comparing the budgeted figures with actual performance for
calculating the variances, if any, so that corrective actions may
be taken in future. He objective working capital budget is to
ensure availability of funds as and needed, and to ensure effective
utilization of these resources. The successful implementation of
working capital budget involves the preparing of separate budget
for each element of working capital, such as, cash, inventories and
receivables etc. ANALYSIS OF SHORT TERM FINANCIAL POSITION OR TEST
OF LIQUIDITYThe short term creditors of a company such as suppliers
of goods of credit and commercial banks short-term loans are
primarily interested to know the ability of a firm to meet its
obligations in time. The short term obligations of a firm can be
met in time only when it is having sufficient liquid assets. So to
with the confidence of investors, creditors, the smooth functioning
of the firm and the efficient use of fixed assets the liquid
position of the firm must be strong. But a very high degree of
liquidity of the firm being tied up in current assets. Therefore,
it is important proper balance in regard to the liquidity of the
firm. Two types of ratios can be calculated for measuring
short-term financial position or short-term solvency position of
the firm.1. Liquidity ratios.2. Current assets movements ratios.A)
LIQUIDITY RATIOSLiquidity refers to the ability of a firm to meet
its current obligations as and when these become due. The
short-term obligations are met by realizing amounts from current,
floating or circulating assts. The current assets should either be
liquid or near about liquidity. These should be convertible in cash
for paying obligations of short-term nature. The sufficiency or
insufficiency of current assets should be assessed by comparing
them with short-term liabilities. If current assets can pay off the
current liabilities then the liquidity position is satisfactory. On
the other hand, if the current liabilities cannot be met out of the
current assets then the liquidity position is bad. To measure the
liquidity of a firm, the following ratios can be calculated:1.
CURRENT RATIO2. QUICK RATIO3. ABSOLUTE LIQUID RATIO1. CURRENT
RATIOCurrent Ratio, also known as working capital ratio is a
measure of general liquidity and its most widely used to make the
analysis of short-term financial position or liquidity of a firm.
It is defined as the relation between current assets and current
liabilities. Thus,CURRENT RATIO = CURRENT ASSETS/ CURRENT
LIABILITESThe two components of this ratio are:1) CURRENT ASSETS2)
CURRENT LIABILITESCurrent assets include cash, marketable
securities, bill receivables, sundry debtors, inventories and
work-in-progresses. Current liabilities include outstanding
expenses, bill payable, dividend payable etc.A relatively high
current ratio is an indication that the firm is liquid and has the
ability to pay its current obligations in time. On the hand a low
current ratio represents that the liquidity position of the firm is
not good and the firm shall not be able to pay its current
liabilities in time. A ratio equal or near to the rule of thumb of
2:1 i.e. current assets double the current liabilities is
considered to be satisfactory.CALCULATION OF CURRENT RATIOe.g
(Rupees in crore).Year201120122013
Current Assets81.2983.1213,6.57
Current Liabilities27.4220.5833.48
Current Ratio2.96:14.03:14.08:1
Interpretation:-As we know that ideal current ratio for any firm
is 2:1. If we see the current ratio of the company for last three
years it has increased from 2011 to 2013. The current ratio of
company is more than the ideal ratio. This depicts that companys
liquidity position is sound. Its current assets are more than its
current liabilities.2. QUICK RATIOQuick ratio is a more rigorous
test of liquidity than current ratio. Quick ratio may be defined as
the relationship between quick/liquid assets and current or liquid
liabilities. An asset is said to be liquid if it can be converted
into cash with a short period without loss of value. It measures
the firms capacity to pay off current obligations immediately.QUICK
RATIO = QUICK ASSETS CURRENT LIABILITESWhere Quick Assets are:1)
Marketable Securities2) Cash in hand and Cash at bank.3) Debtors.A
high ratio is an indication that the firm is liquid and has the
ability to meet its current liabilities in time and on the other
hand a low quick ratio represents that the firms liquidity position
is not good.As a rule of thumb ratio of 1:1 is considered
satisfactory. It is generally thought that if quick assets are
equal to the current liabilities then the concern may be able to
meet its short-term obligations. However, a firm having high quick
ratio may not have a satisfactory liquidity position if it has slow
paying debtors. On the other hand, a firm having a low liquidity
position if it has fast moving inventories.CALCULATION OF QUICK
RATIOe.g. (Rupees in Crore)Year201120122013
Quick Assets44.1447.4361.55
Current Liabilities27.4220.5833.48
Quick Ratio1.6 : 12.3 : 11.8 : 1
Interpretation : A quick ratio is an indication that the firm is
liquid and has the ability to meet its current liabilities in time.
The ideal quick ratio is 1:1. Companys quick ratio is more than
ideal ratio. This shows company has no liquidity problem.3.
absolute liquid ratioAlthough receivables, debtors and bills
receivable are generally more liquid than inventories, yet there
may be doubts regarding their realization into cash immediately or
in time. So absolute liquid ratio should be calculated together
with current ratio and acid test ratio so as to exclude even
receivables from the current assets and find out the absolute
liquid assets. Absolute Liquid Assets includes :Absolute liquid
ratio = absolute liquid assets CURRENT LIABILITESAbsolute liquid
assets = cash & bank balances.e.g. (Rupees in
Crore)Year201120122013
Absolute Liquid Assets4.691.795.06
Current Liabilities27.4220.5833.48
Absolute Liquid Ratio.17 : 1.09 : 1.15 : 1
Interpretation : These ratio shows that company carries a small
amount of cash. But there is nothing to be worried about the lack
of cash because company has reserve, borrowing power & long
term investment. In India, firms have credit limits sanctioned from
banks and can easily draw cash.B) current assets movement
ratiosFunds are invested in various assets in business to make
sales and earn profits. The efficiency with which assets are
managed directly affects the volume of sales. The better the
management of assets, large is the amount of sales and profits.
Current assets movement ratios measure the efficiency with which a
firm manages its resources. These ratios are called turnover ratios
because they indicate the speed with which assets are converted or
turned over into sales. Depending upon the purpose, a number of
turnover ratios can be calculated. These are :1. Inventory Turnover
Ratio2. Debtors Turnover Ratio3. Creditors Turnover Ratio4. Working
Capital Turnover RatioThe current ratio and quick ratio give
misleading results if current assets include high amount of debtors
due to slow credit collections and moreover if the assets include
high amount of slow moving inventories. As both the ratios ignore
the movement of current assets, it is important to calculate the
turnover ratio.1. Inventory Turnover or Stock Turnover Ratio :Every
firm has to maintain a certain amount of inventory of finished
goods so as to meet the requirements of the business. But the level
of inventory should neither be too high nor too low. Because it is
harmful to hold more inventory as some amount of capital is blocked
in it and some cost is involved in it. It will therefore be
advisable to dispose the inventory as soon as possible.inventory
turnover ratio = cost of good sold Average inventoryInventory
turnover ratio measures the speed with which the stock is converted
into sales. Usually a high inventory ratio indicates an efficient
management of inventory because more frequently the stocks are sold
; the lesser amount of money is required to finance the inventory.
Where as low inventory turnover ratio indicates the inefficient
management of inventory. A low inventory turnover implies over
investment in inventories, dull business, poor quality of goods,
stock accumulations and slow moving goods and low profits as
compared to total investment.average stock = opening stock +
closing stock 2(Rupees in Crore)Year201120122013
Cost of Goods sold110.6103.296.8
Average Stock73.5936.4255.35
Inventory Turnover Ratio1.5 times2.8 times1.75 times
Interpretation : These ratio shows how rapidly the inventory is
turning into receivable through sales. In 2012 the company has high
inventory turnover ratio but in 2013 it has reduced to 1.75 times.
This shows that the companys inventory management technique is less
efficient as compare to last year.2. Inventory conversion
period:Inventory conversion period = 365 (net working days)
inventory turnover ratioe.g.Year201120122013
Days365365365
Inventory Turnover Ratio1.52.81.8
Inventory Conversion Period243 days130 days202 days
Interpretation : Inventory conversion period shows that how many
days inventories takes to convert from raw material to finished
goods. In the company inventory conversion period is decreasing.
This shows the efficiency of management to convert the inventory
into cash.3. debtors turnover ratio :A concern may sell its goods
on cash as well as on credit to increase its sales and a liberal
credit policy may result in tying up substantial funds of a firm in
the form of trade debtors. Trade debtors are expected to be
converted into cash within a short period and are included in
current assets. So liquidity position of a concern also depends
upon the quality of trade debtors. Two types of ratio can be
calculated to evaluate the quality of debtors.a) Debtors Turnover
Ratiob) Average Collection PeriodDebtors Turnover Ratio = Total
Sales (Credit) Average DebtorsDebtors velocity indicates the number
of times the debtors are turned over during a year. Generally
higher the value of debtors turnover ratio the more efficient is
the management of debtors/sales or more liquid are the debtors.
Whereas a low debtors turnover ratio indicates poor management of
debtors/sales and less liquid debtors. This ratio should be
compared with ratios of other firms doing the same business and a
trend may be found to make a better interpretation of the
ratio.average debtors= opening debtor+closing debtor
2e.g.Year201120122013
Sales166.0151.5169.5
Average Debtors17.3318.1922.50
Debtor Turnover Ratio9.6 times8.3 times7.5 times
Interpretation : This ratio indicates the speed with which
debtors are being converted or turnover into sales. The higher the
values or turnover into sales. The higher the values of debtors
turnover, the more efficient is the management of credit. But in
the company the debtor turnover ratio is decreasing year to year.
This shows that company is not utilizing its debtors efficiency.
Now their credit policy become liberal as compare to previous
year.4. average collection period :Average Collection Period = No.
of Working Days Debtors Turnover RatioThe average collection period
ratio represents the average number of days for which a firm has to
wait before its receivables are converted into cash. It measures
the quality of debtors. Generally, shorter the average collection
period the better is the quality of debtors as a short collection
period implies quick payment by debtors and vice-versa.Average
Collection Period = 365 (Net Working Days) Debtors Turnover
RatioYear201120122013
Days365365365
Debtor Turnover Ratio9.68.37.5
Average Collection Period38 days44 days49 days
Interpretation : The average collection period measures the
quality of debtors and it helps in analyzing the efficiency of
collection efforts. It also helps to analysis the credit policy
adopted by company. In the firm average collection period
increasing year to year. It shows that the firm has Liberal Credit
policy. These changes in policy are due to competitors credit
policy.5. Working capital turnover ratio :Working capital turnover
ratio indicates the velocity of utilization of net working capital.
This ratio indicates the number of times the working capital is
turned over in the course of the year. This ratio measures the
efficiency with which the working capital is used by the firm. A
higher ratio indicates efficient utilization of working capital and
a low ratio indicates otherwise. But a very high working capital
turnover is not a good situation for any firm.Working Capital
Turnover Ratio = Cost of Sales Net Working CapitalWorking Capital
Turnover = Sales Networking Capitale.g.Year201120122013
Sales166.0151.5169.5
Networking Capital53.8762.52103.09
Working Capital Turnover3.082.41.64
Interpretation : This ratio indicates low much net working
capital requires for sales. In 2013, the reciprocal of this ratio
(1/1.64 = .609) shows that for sales of Rs. 1 the company requires
60 paisa as working capital. Thus this ratio is helpful to forecast
the working capital requirement on the basis of
sale.Inventories(Rs. in Crores)Year2010-20112011-20122012-2013
Inventories37.1535.6975.01
Interpretation : Inventories is a major part of current assets.
If any company wants to manage its working capital efficiency, it
has to manage its inventories efficiently. The graph shows that
inventory in 2010-2011 is 45%, in 2011-2012 is 43% and in 2012-2013
is 54% of their current assets. The company should try to reduce
the inventory upto 10% or 20% of current assets.Cash bnak balance
:(Rs. in Crores)Year2010-20112011-20122012-2013
Cash Bank Balance4.691.795.05
Interpretation : Cash is basic input or component of working
capital. Cash is needed to keep the business running on a
continuous basis. So the organization should have sufficient cash
to meet various requirements. The above graph is indicate that in
2011 the cash is 4.69 crores but in 2012 it has decrease to 1.79.
The result of that it disturb the firms manufacturing operations.
In 2013, it is increased upto approx. 5.1% cash balance. So in
2013, the company has no problem for meeting its requirement as
compare to 2012.debtors :(Rs. in
Crores)Year2010-20112011-20122012-2013
Debtors17.3319.0525.94
Interpretation : Debtors constitute a substantial portion of
total current assets. In India it constitute one third of current
assets. The above graph is depict that there is increase in
debtors. It represents an extension of credit to customers. The
reason for increasing credit is competition and company liberal
credit policy.current assets :(Rs. in
Crores)Year2010-20112011-20122012-2013
Current Assets81.2983.15136.57
Interpretation : This graph shows that there is 64% increase in
current assets in 2013. This increase is arise because there is
approx. 50% increase in inventories. Increase in current assets
shows the liquidity soundness of company.current liability :(Rs. in
Crores)Year2010-20112011-20122012-2013
Current Liability27.4220.5833.48
Interpretation : Current liabilities shows company short term
debts pay to outsiders. In 2013 the current liabilities of the
company increased. But still increase in current assets are more
than its current liabilities.net wokring capital :(Rs. in
Crores)Year2010-20112011-20122012-2013
Net Working Capital53.8762.53103.09
Interpretation : Working capital is required to finance day to
day operations of a firm. There should be an optimum level of
working capital. It should not be too less or not too excess. In
the company there is increase in working capital. The increase in
working capital arises because the company has expanded its
business.
MEANING OF INVESTMENTIn simple terms, Investment refers to
purchase of financial assets. While Investment Goods are those
goods, which are used for further production.
Investment implies the production of new capital goods, plants
and equipments. John Keynes refers investment as real investment
and not financial investment.Investment is a conscious act of an
individual or any entity that involves deployment of money (cash)
in securities or assets issued by any financial institution with a
view to obtain the target returns over a specified period of
time.Target returns on an investment include:1. Increase in the
value of the securities or asset, and/or2. Regular income must be
available from the securities or asset.
TYPES OF INVESTMENTDifferent types or kinds of investment are
discussed in the following points.
AUTONOMOUS INVESTMENTInvestment which does not change with the
changes in income level, is called as Autonomous or Government
Investment.Autonomous Investment remains constant irrespective of
income level. Which means even if the income is low, the
autonomous, Investment remains the same. It refers to the
investment made on houses, roads, public buildings and other parts
of Infrastructure. The Government normally makes such a type of
investment.
INDUCED INVESTMENTInvestment which changes with the changes in
the income level, is called as Induced Investment. Induced
Investment is positively related to the income level. That is, at
high levels of income entrepreneurs are induced to invest more and
vice-versa. At a high level of income, Consumption expenditure
increases this leads to an increase in investment of capital goods,
in order to produce more consumer goods.FINANCIAL
INVESTMENTInvestment made in buying financial instruments such as
new shares, bonds, securities, etc. is considered as a Financial
Investment.However, the money used for purchasing existing
financial instruments such as old bonds, old shares, etc., cannot
be considered as financial investment. It is a mere transfer of a
financial asset from one individual to another. In financial
investment, money invested for buying of new shares and bonds as
well as debentures have a positive impact on employment level,
production and economic growth.REAL INVESTMENTInvestment made in
new plant and equipment, construction of public utilities like
schools, roads and railways, etc., is considered as Real
Investment.Real investment in new machine tools, plant and
equipments purchased, factory buildings, etc. increases employment,
production and economic growth of the nation. Thus real investment
has a direct impact on employment generation, economic growth,
etc.PLANNED INVESTMENTInvestment made with a plan in several
sectors of the economy with specific objectives is called as
Planned or Intended Investment. Planned Investment can also be
called as Intended Investment because an investor while making
investment make a concrete plan of his investment.
UNPLANNED INVESTMENTInvestment done without any planning is
called as an Unplanned or Unintended Investment. In unplanned type
of investment, investors make investment randomly without making
any concrete plans. Hence it can also be called as Unintended
Investment. Under this type of investment, the investor may not
consider the specific objectives while making an investment
decision.GROSS INVESTMENTGross Investment means the total amount of
money spent for creation of new capital assets like Plant and
Machinery, Factory Building, etc.NET INVESTMENTNet Investment is
Gross Investment less (minus) Capital Consumption (Depreciation)
during a period of time, usually a year.It must be noted that a
part of the investment is meant for depreciation of the capital
asset or for replacing a worn-out capital asset. Hence it must be
deducted to arrive at net investment.
Investment DecisionsInvestment decisions of a firm are generally
known as the capital budgeting, or capital expenditure decision. It
is defined as the firm decision to invest its current funds most
efficiently in the long-term assets in anticipation of an expected
flow of benefits over a series of years (the long-term assets are
those that affects the firms operations beyond the one-year period)
it includes expansion, acquisition, modernization and replacement
ofthe long-term assets, sale of a division or business(divestment),
change in the methods of sales distribution, an advertisement
campaign, research and development programme and employee training,
shares (tangible and intangible assets that create value).
.According to Experts, investment decisions is decisions that
influence a firms growth in the long-term, affect the risk of the
firm, involve commitment of large amount of funds, are irreversible
or reversible at substantial loss, and among the most difficult
decisions to make. Horne, define investment decisions as the
allocation of capital to investment proposal whose benefits are to
be realized in the future and includes, new product or expansion of
existing products, replacement ofequipment or buildings, research
and development, exploration and others.
Objectives of Investment decision in Business:-The fundamental
objectives of all business decisions is to maximize the return on
stock holders equity, there are others factor shaping effective
capital allocation strategies and tactics. Financial management,
therefore, can be effective only if it is based on well formulated
multiple goals and objectives, for a profit making organization,
the primary objective may be to maximize the value of shareholders
wealth, to maximize the total resources, or to maximize owner
equity over the long run.
Importance Of Investment DecisionsInvestment decisions require
special attention because of the following reasons:i. They
influence the firms growth in the long run,ii. They affect the risk
of the firm,iii. They involve commitment of large amount of
funds,iv. They are irreversible, or reversible at substantial
loss,v. They are among the most difficult decisions to make Growth:
The effect of investment decisions extend into the future and have
to be endured for a longer period than the consequences of the
current operating expenditure. A firms decision to invest in long
term asset has a decisive influence on the rate and direction of
growth. A wrong decision can prove disastrous for the continued
survival of the firm; unwanted or unprofitable expansion of asset
will result in heavy operating costs to the firm. On the other
hand, inadequate investment in asset would make it difficult for
the firm to compete successfully and maintain its market share.
Risk: A long-term commitment of fund may also change the risk
complexity of the firm. If the adoption of an investment increase
average gain but causes frequent fluctuations in its earnings, the
firm will become more risky. Thus, investment decisions shape the
basic character of a firm.
Funding: Investment decisions generally involve large amount
offunds, which make it imperative for the firm to plan its
investment programmes very carefully and make advance arrangement
for procuring finances internally and externally.Irreversible: Most
investment decisions are irreversible. It is difficult to find a
market for such capital items once they have been acquired. The
firm will incur heavy losses if such assets are scrappedComplexity:
Investment decisions are among the firms most difficult decisions.
They are an assessment of future events, which are difficult to
predict. It is really a complex problem to correctly estimate the
future cash flows of an investment. Economic, political, social and
technology forces cause the uncertainty in cash flow
estimation.
Factors influencing investment decisionCapital investment
decisions are not governed by one or two factors, because the
investment problem is not simply one of replacing old equipment by
a new one, but is concerned with replacing an existing process in a
system with another process which makes the entire system more
effective. We discuss below some of the relevant factors that
affects investment decisions:Management Outlook: If the management
is progressive and has an aggressively marketing and growth
outlook, it will encourage innovation and favor capital proposals
which ensure better productivity on quality or both. In some
industries where the product being manufactured is a simple
standardized one, innovation is difficult and management would be
extremely cost conscious. In contrast, in industries such as
chemicals and electronics, a firm cannot survive, if it follows a
policy of 'make-do' with its existing equipment. The management has
to be progressive and innovation must be encouraged in such
cases.
Competitors Strategy:
Competitors' strategy regarding capital investment exerts
significant influence on the investment decision of a company. If
competitors continue to install more equipment and succeed in
turning out better products, the existence of the company not
following suit would be seriously threatened. This reaction to a
rival's policy regarding capital investment often forces decision
on a company'
Opportunities created by technological change: Technological
changes create new equipment which may represent a major change in
process, so that there emerges the need for re-evaluation of
existing capital equipment in a company. Some changes may justify
new investments. Sometimes the old equipment which has to be
replaced by new equipment as a result of technical innovation may
be downgraded to some other applications, A proper evaluation of
this aspect is necessary, but is often not given due consideration.
In this connection, we may note that the cost of new equipment is a
major factor in investment decisions. However the management should
think in terms of incremental cost, not the full accounting cost of
the new equipment because cost of new equipment is partly offset by
the salvage value of the replaced equipment. In such analysis an
index called the disposal ratio becomes relevant.Disposal ratio =
(Salvage value, Alternative use value) / Installed cost
Market forecast: Both short and long run market forecasts are
influential factors in capital investment decisions. In order to
participate in long-run forecast for market potential critical
decisions on capital investment have to be taken.
Fiscal Incentives: Tax concessions either on new investment
incomes or investment allowance allowed on new investment
decisions, the method for allowing depreciation deduction allowance
also influence new investment decisions.
Cash flow Budget: The analysis of cash-flow budget which shows
the flow of funds into and out of the company may affect capital
investment decision in two ways. 'First, the analysis may indicate
that a company may acquire necessary cash to purchase the equipment
not immediately but after say, one year, or it may show that the
purchase of capital assets now may generate the demand for major
capital additions after two years and such expenditure might clash
with anticipated other expenditures which cannot be postponed.
Secondly, the cash flow budget shows the timing of cash flows for
alternative investments and thus helps management in selecting the
desired investment project.
Non-economic factors: New equipment may make the workshop a
pleasant place and permit more socializing on the job. The effect
would be reduced absenteeism and increased productivity. It may be
difficult to evaluate the benefits in monetary terms and as such we
call this as non-economic factor. Let us take one more example.
Suppose the installation of a new machine ensures greater safety in
operation. It is difficult to measure the resulting monetary saving
through avoidance of an unknown number of injuries. Even then,
these factors give tangible results and do influence investment
decisions.Investment Decisions Types There are many ways to
classify investment. One classification is as follows: Expansion of
existing business Expansion of new business Replacement and
modernization.
Expansion and diversification
A company may add capacity to its existing product lines to
expand existing operations. For example, the Gujarat state
fertilizer company (GSFC) may increase its plant capacity to
manufacture more urea. It is an example of related diversification.
A firm may expand its activities in a new business. Expansion of a
new business requires investment in new products and a new kind of
production activity within the firm. If a packaging manufacturing
company invests in a new plant and machinery to produce ball
bearing, which the firm has not manufactured before, this
represents expansion of new business or unrelated diversification.
Sometimes a company acquires existing firms to expand its business.
In either case, the firm makes investment in the expectation of
additional revenue. Investments in existing or new products may
also be called as revenue-expansion investments.
Replacement and modernization
The main adjective of modernization and replacement is to
improve operating efficiency and reduce costs, cost savings will
reflect in the increased profits, but the firms revenues may remain
unchanged. Assets become outdated and obsolete with technological
changes. The firm must decide to replace those assets with new
assets that operate more economically. If a cement company changes
from semi-automatic drying equipment to fully automatic drying
equipment, it is an example of modernization and replacement.
Replacement decisions help to introduce more efficient and
economical assets and therefore, are also called cost-reduction
investments however; replacement decisions that involve substantial
modernization and technological improvement expand revenues as well
as reduce costs.
Conclusion:-Globalization, accompanied by open trade and
investment, provides the conditions for improved economic
prosperity as well as environmental protection. Business continues
to be an important and engaged actor in the pursuit of sustainable
development, and in partnership with others, can make its
contribution most effectively in the framework of economic growth,
more open trade and investment and a conducive regulatory
framework.Capital investment decisions are long-term corporate
finance decisions relating to fixed assets and capital structure.
Decisions are based on several inter-related criteria. Corporate
management seeks to maximize the value of the firm by investing in
projects which yield appositive net present value. When valued
using an appropriate discount rate. These projects must also be
financed appropriately. If no such opportunities exist, maximizing
shareholders value dictates that management returns excess cash to
shareholders. Capital investment decisions thus compromise an
investment decision, a financial decision, and a dividend
decisions. A positive investment decision can only be taken the
application of ratio analysis.
BIBLIOGRAPHY:
www.investopedia.com/terms/w/workingcapitalmanagement.asp
http://en.wikipedia.org/wiki/Working_capital
http://www.allprojectreports.com/MBA-Projects/Finance-Project-Report/working_capital_management/working_capital_management.htm
http://businesscasestudies.co.uk/business-theory/finance/investment-decisions.html
http://en.wikipedia.org/wiki/Investment_decisions
http://www.investopedia.com/walkthrough/corporate-finance/4/capital-investment-decisions/introduction.aspx32