working capital management

FINANCIAL MANAGEMENT

DEPARTMENT OF BUSINESS ADMINISTRATION

PREPARED BY:

SOHAM PATADIYA

JAYDEV JADEJA

GOPAL VAGHELA

ANKITA

Guided BY:

Dr. b. c. ajmera

Working capital Management

DEFINITION

• Working capital is the financing in a small business that helps a company pay its trade creditors and cash flow – it is the finance that businesses need for their day-to-day trading operations.

“TYPES OF SOURCES OF WORKING CAPITAL” (1)Short term source of working capital.(2) Long term source of working capital.

Short Term Sources of Working Capital Financing

FACTORING: Factoring is a traditional source of short term funding.

Factoring facility arrangements tend to be restrictive and entering into a whole-turnover factoring facility can lead to aggressive chasing of outstanding invoices from clients, and a loss of control of a company’s credit function.

INSTALLMENT CREDIT: Installment credit is a form of finance to pay for goods or

services over a period through the payment of principal and interest in regular payments.

INSTALLMENT CREDIT: Installment credit is a form of finance to pay for goods or

services over a period through the payment of principal and interest in regular payments.

BANK OVERDRAFT: A bank overdraft is when someone is able to spend more

than what is actually in their bank account. The overdraft will be limited. A bank overdraft is also a type of loan as the money is technically borrowed.

COMMERCIAL PAPERS :• A commercial paper is an unsecured promissory note.

Commercial paper is a money-market security issued by large corporations to get money to meet short term debt obligations e.g. payroll, and is only backed by an issuing bank or corporation’s promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings will be able to sell their commercial paper at a reasonable price.

LETTER OF CREDIT: A letter of credit is a document that a financial institution

issues to a seller of goods or services which says that the issuer will pay the seller for goods/services the seller delivers to a third-party buyer. The issuer then seeks reimbursement from the buyer or from the buyer’s bank. The document is essentially a guarantee to the seller that it will be paid by the issuer of the letter of credit regardless of whether the buyer ultimately fails to pay. In this way, the risk that the buyer will fail to pay is transferred from the seller to the letter of credit’s issuer.

Long Term Sources of Working Capital Financing

EQUITY CAPITAL:• Equity capital refers to the portion of a company’s equity

that has been obtained (or will be obtained) by trading stock to a shareholder for cash or an equivalent item of capital value. Equity comprises the nominal values of all equity issued (that is, the sum of their “par values”). Share capital can simply be defined as the sum of capital (cash or other assets) the company has received from investors for its shares.

LOANS:A loan is a type of debt which it entails the redistribution of

financial assets over time, between the lender and the borrower. In a loan, the borrower initially receives or borrows an amount of money from the lender, and is obligated to pay back or repay an equal amount of money to the lender at a later time. Typically, the money is paid back in regular installments, or partial repayments; in an annuity, each installment is the same amount. Acting as a provider of loans is one of the principal tasks for financial institutions like banks.

Principle of working capital management policy

• The following are the 4 principles of working capital management policy:

• 1) Principle of equity position: as per this principle every investment in the current assets should contribute to the net worth of the firm. The position of current assets can be well judged by the two ratios; current assets to total asset and current asset to total sales.

• 2) Principle of cost of capital: different sources of working capital finance have different cost of capital. Generally there is –ve relationship between the risk and cost of capital, which means more the risk less will be the cost and less the risk more will be the cost. So there should be balance between the two.

• 3) Principle of maturity of payment: as per this principle the firm should make an every effort regarding the maturity of payment. In case the period to pay back the liabilities is short than it becomes difficult for the firm to meet it obligations in time.

• 4) Principle of risk variation: there is direct relationship between risk and profitability.

• If the firm makes large investment in current asset→ increase liquidity→ reduce risk→ decrease the opportunity for gain for the firm.

1. Cash2. Marketable securities3. Accounts Receivable4. Inventory

Components of working capital

1. CASH

• Cash is one of the most liquid and important components of working capital.

• Holding cash involves cost because the worth of cash held, after a year will be less than the value of cash as on today.

• Excess of cash balance should not be kept in business because cash is a non-earning asset.

• Hence, a proper and judicious cash management is of utmost importance in business.

2. MARKETABLE SECURITIES

• These securities also don't give much yield to the business because of two reasons,

(i) Marketable securities act as a substitute for cash, (ii) These are used as temporary investments. • These are held not for hypothetical balances,

but only as a guard against possible shortage of bank credit.

• Eg. Stock, bond etc…

3. ACCOUNTS RECIEVABLE

• Too many debtors always lock up the firm's resources especially during inflationary tendencies. This is a two step account.

• When goods are sold, inventories are reduced and accounts receivables are created. When payment is made, debtors reduce and cash level increases.

• Thus, quantum of debtors depends on two things, • (i) volume of Credit sales • (ii) average length of time between sales and

collections.

• The entrepreneur should determine the optimal credit standards.

• An optimal credit policy should be established and the firm's operations should be continuously monitored to achieve higher sales and minimum bad debt losses.

4. INVENTORY

• Inventories represent a significant amount of firm's assets.

• Inventories must be properly managed so that this investment doesn't become too large, as it would result in blocked capital which could be put to productive use elsewhere.

• On the other hand, having too little or small inventory could result in loss of sales or loss of customer goodwill. An optimum level of inventory, therefore, should be maintained.

The working capital needs of a business are influenced by numerous factors:

• Nature of Enterprise• Manufacturing/Production Policy• Operations• Market Condition• Availability of Raw Material• Growth and Expansion• Price Level Changes• Manufacturing Cycle

ESTIMATION OR FORECASTING OF WORKING CAPITAL

• Forecasting of Working Capital refers to the estimation of Working Capital Requirement for a certain future period. It is made so as to indicate the amount of Working Capital required for the future period and the sources from which the required amount of Working Capital can be financed.

PROCEDURE FOR ESTIMATION/FORECASTING OF WORKING CAPITAL

• Calculation of average production: The average estimated production per period (i.e., per day or per week or per month) is to be calculated first.

• Calculation of average cost and sales: Secondly, the average cost of each element of cost as well as the total cost per period is to be calculated—that is, the cost of material, wages and overhead per day or per week or per month and the total cost per month to be calculated. The profit per period is to be added to the total cost per period so as to get the sales per period.

• Calculation of period of block: The period of block of each element of cost, such as materials, wages and overheads in the operating cycle, are to be separately calculated, that is, the cost of materials blocked in the store, in the production process, in the finished goods and in the debtors; wages and overhead costs blocked in the production process, in the finished goods and in the debtors; and the profit blocked in the debtors, if the profit element of Working Capital is considered.

Following factors should be taken into consideration for the

estimation of Working Capital Requirement: • Expected annual production quantity.• Cost of raw materials, wages and overheads per unit of the

product.• Raw materials holding period in store before use.• Production-processing period.• Finished goods storage period before sale.• Credit period allowed to sundry debtors for credit sales.• Credit period received from the sundry creditors against the

credit purchases of raw materials.

Points to be remembered while estimating WC

• (1) Profits should be ignored while calculating working capital requirements for the following reasons.

• (a) Profits may or may not be used as working capital• (b) Even if it is used, it may be reduced by the amount of Income tax,

Drawings, Dividend paid etc.• (2) Calculation of WIP depends on the degree of completion as regards

to materials, labour and overheads. However, if nothing is mentioned in the problem, take 100% of the value as WIP. Because in such a case, the average period of WIP must have been calculated as equivalent period of completed units.

• (3) Calculation of Stocks of Finished Goods and Debtors should be made at cost unless otherwise asked in the question.

There are various approaches which have been applied in practice for estimating the working capital needs of a firm. Let’s discuss some of them in

brief. • 1. Conservative Approach The conservative approach states that the proportion of

current assets to current liabilities should be kept at 2:1. Is this proportion is to be kept the firm would be able to meet its obligations on time and hence its financial solvency would not be in trouble. However, the limitation of this approach is that it suggests only quantitative measure. It does not suggest as to what type of assets are to be included in current assets. If the current assets contain stock, which is outdated or receivable which are not collectable, than the amount of current assets has no meaning. Further, in the present scenario no firm maintains this ratio, as it’s too difficult for them to maintain such a high level of current assets.

• 2. Components Approach• Here we take up one of the planning models of working

capital to estimate working capital. The method adopted here attempts at estimation of working capital and its components by taking into account, the period for which the various items remain as stock or as outstanding, the cost structure of production and annual production. It assumes even production and even sales, throughout and what is produced is completely sold.

• 3. Operating Cycle Approach• It was earlier referred to that working capital is also known

as revolving capital. That is, a circular path of conversion/re-conversion takes place. Consider this example. You start your business operation with an initial investment. With credit extended by expense creditors (labor, employees, utilities, etc.) you start production process. Goods of varying levels of finish result. This is what we call as work-in-process or work-in-progress. Once complete processing is done, you get finished goods. Until these goods are sold, they remain in stock. Sales may be for cash and/or on credit basis. You need to wait a little to realize cash from the credit customers.

The realized cash is used to pay creditors. You need to maintain a cash balance for day-to-day transactions as well as for meeting sudden spurt in payment obligations accompanied by sluggish cash collections from debtors. Thus a revolution or cycle from cash to raw materials to Work in Progress (WIP), to finished goods, to debtors, and back to cash is taking place. This revolution or cycle is known as operating cycle.

INVENTARY MANAGEMENT

DEFINITION OF INVENTORY:-

• A physical resources that a firm holds in stock with the intent of selling it or transforming it into a more valuable state.

NATURE OF INVENTORY:- ADDING VALUE THROUGH INVENTORIES:-

• Quality• Speed• Flexibility• cost

FUNCTIONS OF INVENTORY:-

• To meet the anticipated customer demand• To smooth production requirements • To decouple operations• To protect against stock outs• To hedge against price increases• To permit operations• To take advantage of quantity discounts.

CLASSIFICATION OF INVENTORIES COST:-

• Carrying costs• Procurement costs• Shortage costs • Item costs• Capacity associated costs

FORMS OF INVENTORIES:-

• Raw materials inventories • Work-in –process inventories• M.R.O. inventories/ spare part inventories• Finished inventories

WHAT IS INVENTORY MANAGEMENT?

MOTIVE OF HOLDING INVENTORY:-

• Transaction motive• Precautionary motive• Speculative motive

INVENTORY TURNOVER RATIO:- It means how many times a company inventory is sold and

replaced ( finished product)

Generally calculated as:- sales ÷ inventory

However, it may also be calculated as:- COGS ÷ average inventory

Inventory ratio = value of material consumed during a period ÷ average value of inventory during that period.

INVENTORY CONTROL:-

Inventory control is the means by which materials of the correct quality and in correct quantity are made available as and when required with due regards to economic in storage and ordering cost. Here the desired level of inventory can neither be high or low because high level inventory will lead to increase in carrying cost while low level of inventory will lead to increase in ordering cost.

ACTIVITY OF INVENTORY CONTROL NORMALLY INCLUDE THE FOLLOWING:-

• Determination of the limits of the inventories to be held.

• Determination of the inventory policies.

• Selling out of investments patterns and its regulations as per individual and collective requirements.

• Follow up to examine the work of inventory policy and effect change as and when needed.

OBJECTIVES OF INVENTORY CONTROL:-

• To ensure smooth flow of stock of stock• To provide for required quality of materials• To control investment in stock• Protecting against fluctuating demand• Minimization of risk and uncertainty.• Minimization of material cost.

TECHNIQUES OF INVENTORY MANAGEMENT:-

ABC Analysis 10% of total number of items carries 70% of the value ‘A’

group items. 20% of total numbers of items account for only about 20%

consumption value - ‘B’ group items. 70% of total number account for only about 10% of

consumption value - ‘C’ group items.

THANKYOU…