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Working capital management
Decisions 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.The management of working capital involves managing
inventories, accounts receivable and payable, and cash. Working capital
management is a significant concept in financial management due to the fact that it
plays a pivotal role in keeping the wheels of the business enterprise running.
Implementing an effective working capital management system is an excellent way
for many companies to improve their earnings.
Concept of working capital:
Hoagland defines working capital as follows:
Working capital is descriptive of that capital which is not fixed. But, the more
common use of working capital is to consider it as the difference between the book
value of the current assets and the current liabilities.
Working capital, also known as net working capital or NWC, circulating capital
and revolving capital is a financial metric which represents operating
liquidity available to a business. Its magnitude & composition keeps on changing
continuously in the course of business. Along with fixed assets such as plant and
equipment, working capital is considered a part of operating capital. It 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.
Working Capital = Current Assets Current Liabilities
Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company currently is unable
to meet its short-term liabilities with its current assets
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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, accountsreceivable and payable and cash.
If a company's current assets do not exceed its current liabilities, then it may run
into trouble paying back creditors in the short term. The worst-case scenario is
bankruptcy. A declining working capital ratio over a longer time period could also
be a red flag that warrants further analysis. For example, it could be that the
company's sales volumes are decreasing and, as a result, its accounts receivables
number continues to get smaller and smaller.
Working capital also gives investors an idea of the company's underlying
operational efficiency. Money that is tied up in inventory or money that customers
still owe to the company cannot be used to pay off any of the
company's obligations. So, if a company is not operating in the most efficient
manner (slow collection), it will show up as an increase in the working capital.
This can be seen by comparing the working capital from one period to
another; slow collection may signal an underlying problem in the company'soperations.
CLASSIFICATION OF WORKING CAPITAL
Working capital can be classified as follows:
On the basis of time
On the basis of concept
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Determining the Amount of Working Capital
Working capitalis the result of subtracting current liabilities from current assets.It is a measure of a company's solvency, its capacity to make large purchases and
take advantage of bulk discounts, and its ability to attract customers by offering
advantageous credit terms.
Components of working capital:
Working capital comprises of 2 major components;
a) Current assets
b) Current liabilities
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Current assets and current liabilities are..........
In accounting, a current asset is an asset on the balance sheet which is expected to
be sold or otherwise used up in the near future, usually within one year, or
one business cycle - whichever is longer.
Current assets include cash, cash equivalents, accounts receivable, inventory
including raw materials; work in progress; finished stock, the portion of prepaid
accounts which will be used within a year, short term advances, short-term
investments, sundry debtors, accrued incomes, and marketable securities.
On the balance sheet, assets will typically be classified into current assets
and long-term assets.
Current Assets = Cash + Bank + Debtors + Bills Receivable + Short Term
Investment + Inventory + Prepaid Expenses
Current liabilities are the debts a company owes which must be paid within one
year. They are the opposite of current assets.
Current liabilities includes things such as short term loans, accounts payable,
dividends and interest payable, bonds payable, consumer deposits, reserves for
Federal taxes, bank overdraft, and other liabilities maturing within one period.
Current liabilities = creditors + accounts payable + short term borrowings +
accrued expenses +dividend & taxes payable +bank overdraft.
The current ratio is calculated by dividing total current assets by total current
liabilities. It is frequently used as an indicator of a company's liquidity, its ability
to meet short-term obligations.
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Why should the managers of a business pay special attention to
working capital??????Management must ensure that a business has sufficient working capital. Too little
will result in cash flow problems highlighted by an organization exceeding its
agreed overdraft limit, failing to pay suppliers on time and being unable to claimdiscounts for prompt payment. In the long run, a business with insufficient
working capital will be unable to meet its current obligations and will be forced to
cease trading even if it remains profitable on paper.
On the other hand, if an organization ties up too much of its resources in working
capital it will earn a lower than expected rate of return on capital employed. Again
this is not a desirable situation.
The other problems associated with inadequate & excessive working
capital are:WORKING CAPITAL SHOULD BE ADEQUATE NEITHER
EXCESSIVE NOR INADEQUATE!!!!!!!!!!!!!!
Advantages Of Adequate Working Capital:
Solvency Of the Business
Goodwill
Easy loans
Cash discounts
Regular supply of raw materials
Regular Payments To Employees
Favourable Policy Decisions As Per Market Trends
Quick And Regular Return On Investment
Disadvantages Of Inadequate Working Capital:
Difficulty In Meeting Operational Expenses
Loss Of Favourable Business Opportunity
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Loss Of Goodwill
Reduction in overall efficiency of the business
Cant pay off its short-term liabilities in time.
Economies of scale are not possible.
Difficult for the firm to exploit favourable market situations
Day-to-day liquidity worsens
Improper utilization the fixed assets and ROA/ROI falls sharply
Disadvantages of Excessive Working Capital:
Blockage Of Funds
Excessive Purchasing
Excessive Debtors
Idle funds, non-profitable for business, poor ROI
Unnecessary purchasing & accumulation of inventories over required level
Excessive debtors and defective credit policy, higher incidence of B/D
Overall inefficiency in the organization.
When there is excessive working capital, Credit worthiness suffers
Due to low rate of return on investments, the market value of shares may fall
Factors affecting working capital requirement:
There is no set of universally applicable rules to ascertain working capital needs of
a business organization. A host of factors influencing of working capital needs of a
firm can be categorized into two categories viz., internal factors and external
factors.
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INTERNAL FACTORS:
Nature of Business
Size of Business
Firms production Policy
Firms credit Policy
Access to Money Market
Growth and Expansion of Business
Profit Margin and Dividend Policy
Depreciation Policy
Working capital cycle
Operating Efficiency of Firm.
EXTERNAL FACTORS :
Business Fluctuations.
Technological Development
Transport and Communication Development
Import Policy
Taxation Policy
MANAGEMENT OF WORKING CAPITAL
Management 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,
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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 as
1. 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.
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TANDON COMMITTEE-
Lending Norms:
Ist Recommendation
The borrower has to contribute a minimum 25% of working capital gap from long
term funds.
IInd Recommendation
The borrower has to contribute a minimum of 25% of the total current assets from
long term funds.
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IIIrd Recommendation
The borrower has to contribute the entire core current assets and a minimum of
25% of the balance of the current assets from long term funds.
Maximum Permissable Bank Finance (MPBF):
Calculation of maximum permissible bank finance (MPBF)
Method 1 (Low Risk Category of Borrowers) 0.75(CA-CL)
Method 2 (Medium Risk category of borrowers) 0.75CA-CL
Method 3 (High Risk Category of borrowers) 0.75(CA-CCA)-CL
Where;
CA = Current assets
CL = Currents Liabilities excluding bank overdraft or any Short Term
Bank Borrowings
CCA = Core Current Assets
Practical problems:
1) A proforma cost sheet of raju brothers privatelimited provides the following particulars.
Elements of cost Amount per unit
Raw material
Direct labour
Overheads
Total cost
Profit
Selling price
80
30
60
170
30
200
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The following further particulars are available:
a) Raw materials are in stock for one month
b) Credit allowed by suppliers is one month
c) Credit allowed to customers is two months
d) Lag in payment of wages 1.5 weeks
e) Lag in payment of overheads one month
f) Materials are in process for an average of half month
g) Finished goods are in stock for an average of one month
h) 1/4th of output is sold against cash
Cash in hand and at bank is expected to be Rs. 25000. You are
requested to prepare a statement showing the working capital
needed to finance a level of activity of 104000units of product.
You may assume that production is carried on evenly throughout the
year. Wages and overheads accrue similarly and a period of 4 weeks
is equivalent to a month.
(2) Calculate the working capital of royal industries from thefollowing particular:
a) Annual expenses:
Wages Rs. 52000
Stores and materials Rs. 9600
Office salaries Rs. 12480
Rent Rs. 2000
Other expenses Rs. 9600
b) Average amount of stocks to be maintained
Finished goods stock Rs. 1000
Material/stores stock Rs. 1600
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c) Expenses paid in advance
(Quarterly advance) Rs. 1600 p.a.
d) Annual sales
Home market Rs. 62400
Foreign market Rs. 15600
e) Lag in payment of
Wages 1.5 weeks
Stores and material 1.5 months
Office salaries 0.5 months
Rent 6 months
Other expenses 1.5 months
f) Credit allowed to customers
Home market 6 months
Foreign market 1.5 months
Concept of operating cycle
Proper and Effective working capital forecasting and control on working capital
will lead to efficient working capital management. The effectiveness in the above
twin can be achieved if the complete information about the operating cycle is
known.
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The working capital cycle can be defined as:
The period of time which elapses between the point at which cash begins to
be expended on the production of a product and the collection of cash from a
customer.
The working capital cycle measures the amount of time that elapses between the
moment when your business begins investing money in a product or service, and
the moment the business receives payment for
that product or service. This doesnt necessarily begin when you manufacture a
productbusinesses often invest money in products when they hire people to
produce goods, or when they buy raw materials.
It is important to measure working capital because..
A good working capital cycle balances incoming and outgoing payments tomaximize working capital. Simply put, you need to know you can afford to
research, produce, and sell your product.
A short working capital cycle suggests a business has good cash flow. For
example, a company that pays contractors in 7 days but takes 30 days to collect
payments has 23 days of working capital to fundalso
known as having a working capital cycle of 23 days. Amazon.com, in contrast,
collects money before it pays for goods. This means the company has a negative
working capital cycle and has more capital available
to fund growth. For a business to grow, it needs access to cashand being able tofree up cash from the working capital cycle is cheaper than other sources of
finance, such as loans.
How It Works in Practice???????
The key to understanding a companys working capital cycle is to know where
payments are collected and made, and to identify areas where the cycle is stretched
and can potentially be reduced.
The working capital cycle is a diagram rather than a mathematical calculation. The
cycle shows all the cash coming in to the business, what it is used for, and how itleaves the business (i.e., what it is spent on).
A simple working capital cycle diagram is shown in Figure 1. The arrows in the
diagram show the movement of assets through the businessincluding cash, but
also other assets such as raw materials and finished
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goods. Each item represents a reservoir of assetsfor example, cash into the
business is converted into labor. The working capital cycle will break down if there
is not a supply of assets moving continually through
the cycle (known as a liquidity crisis).
Figure 1. A simple working capital cycle diagram
The working capital diagram should be customized to show the way capital moves
around your business.
More complex diagrams might include incoming assets such as cash payments,
interest payments, loans, and equity. Items that commonly absorb cash would belabor, inventory, and suppliers.
The key thing to model is the time lag between each item on the diagram. For some
businesses, there may be a very long delay between making the product and
receiving cash from sales. Others may need to purchase raw materials a long time
before the product can be manufactured. Once you have this information, it is
possible to calculate your total working capital cycle, and potentially identify
where time lags within the cycle can be reduced or eliminated.
Operating Cycle:
Time duration required from procurement of raw material and ending with sales
realization.
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Chronological sequence in which working capital cycle operates:
1. Procurement of raw material.
2. Conversion of raw material to WIP
3. Conversion of WIP to Finished goods
4. Sale of Finished Goods (Cash or Credit)
5. Conversion of receivables into cash
Operating Cycle Period:
1. Inventory conversion Period: It is the time required for conversion of raw
material to finished goods.
Inventory conversion period
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Avg. inventory
= _________________
Cost of sales/365
2. Receivables Conversion Period: It is the time required to convert the credit
sales to sales realization.
Receivable conversion period
Accounts receivable
= ___________________
Annual credit sales/365
1. Payables deferral period
Accounts payable + Salaries, etc
= ___________________________
(Cost of sales + selling, general and admn. Expenses)/365
Net operating Cycle= Inventory conversion period+ Receivables conversion
period deferral period (Credit period allowed by suppliers)
Cash conversion cycle = operating cycle payables deferral period.
The diagram below illustrates the working capital cycle for a manufacturingfirm
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The upper
portion of thediagram above
shows in a
simplified
form the chain
of events in a
manufacturing
firm. Each of
the boxes in
the upper part
of the diagramcan be seen as
a tank through
which funds
flow. These tanks, which are concerned with day-to-day activities, have funds
constantly flowing into and out of them.
The chain starts with the firm buying raw materials on credit.
In due course this stock will be used in production, work will be carried out on
the stock, and it will become part of the firms work in progress (WIP)
Work will continue on the WIP until it eventually emerges as the finished product
As production progresses, labour costs and overheads will need to be met
Of course at some stage trade creditors will need to be paid
When the finished goods are sold on credit, debtors are increased
They will eventually pay, so that cash will be injected into the firm
Each of the areas stocks (raw materials, work in progress and finished goods),
trade debtors, cash (positive or negative) and trade creditors can be viewed as
tanks into and from which funds flow.
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Working capital is clearly not the only aspect of a business that affects the amount
of cash:
The business will have to make payments to government for taxation
Fixed assets will be purchased and sold
Lessors of fixed assets will be paid their rent
Shareholders (existing or new) may provide new funds in the form of cash
Some shares may be redeemed for cash
Dividends may be paid
Long-term loan creditors (existing or new) may provide loan finance, loans willneed to be repaid from time to time, and
Interest obligations will have to be met by the business.
Unlike movements in the working capital items, most of these non-working
capital cash transactions are not every day events. Some of them are annual events
(e.g. tax payments, lease payments, dividends, interest and, possibly, fixed asset
purchases and sales). Others (e.g. new equity and loan finance and redemption of
old equity and loan finance) would typically be rarer events.
Importance & use of working capital
Working capital management is very essential as most of the
business falls due to lack of cash than of profits. It is the
business's life blood and every manager's primary task is to help
keep it flowing and to use the cash flow to generate profits. The
faster a business expands, the more cash it will need for working
capital and investment. Good management of working capital
will generate cash, will help improve profits and reduce risks.
For investors, the working capital cycle is most relevant when
analyzing capital-intensive businesses where cash flow is used
to buy inventory. Typically, the working capital cycle of
retailers, consumer goods, and consumer goods manufacturers is
critical to their success.
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The working capital cycle should be considered alongside the
cash conversion cyclea measure of working capital efficiency
that gives clues about the average number of days that working
capital is invested in the operating cycle.
There are two elements in the business cycle that absorb cash
- Inventory (stocks and work-in-progress)
and Receivables (debtors owing you money). The main sources
of cash are Payables (your creditors) and Equity and Loans.
Time & Money Concepts in Working Capital Cycle
Each component of working capital (namely inventory,
receivables and payables) has two dimensions ........TIME .........
and MONEY. When it comes to managing working capital
- TIME IS MONEY. If you can get money to move faster
around the cycle (e.g. collect monies due from debtors more
quickly) or reduce the amount of money tied up (e.g. reduceinventory levels relative to sales), the business will generate
more cash or it will need to borrow less money to fund working
capital. As a consequence, you could reduce the cost of bank
interest or you'll have additional free money available to support
additional sales growth or investment. Similarly, if you can
negotiate improved terms with suppliers e.g. get longer credit or
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an increased credit limit, you effectively create free finance to
help fund future sales.
If you ....... Then ......
Collect receivables
(debtors) faster
You release cash from the cycle
Collect receivables
(debtors) slower
Your receivables soak up cash
Get better credit (in
terms of duration or
amount) from
suppliers
You increase your cash resources
Shift inventory
(stocks) faster
You free up cash
Move inventory
(stocks) slower
You consume more cash
Sources of Additional Working Capital
Sources of additional working capital include the following:
Existing cash reserves Profits (when you secure it as cash !) Payables (credit from suppliers) New equity or loans from shareholders Bank overdrafts or lines of credit Long-term loan.
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(I)From the following information of X & Co , compute the
operating cycle in days and working capital requirements:
Period covered
Average period of credit showed by suppliers
365 days
6 days
Amount
(Rs.000)Average Total Debtors Outstanding
Raw material consumption
Total Production cost
Total cost of sales
Sales for the year (credit)
Value for average stock maintained:
Raw material
W-I-P
Finished goods
420
5840
10220
10950
12775
480
420
660
(II) Given below are the summarized income statements of
infinity limited for the year ended 31st march 2007 and theprojected year 31st march 2008:
31-3-2007
(Rs.Lakhs)
31-3-2008
(Rs.lakhs)
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Sales
Less: Consumption of raw materials
Depreciation
Other manufacturing expenses
Adjustment of opening & closing stock
Cost of goods sold
Gross profit
Less: Interest
General selling expenses
Profit before tax
600
180
12
174
(6)
360
240
30
150
60
720
240
15
186
(9)
432
288
40
200
48
The companys average inventory, debtors & creditors levels for
the year 2006-2007 were as follows:
Rs. In lakhs
Raw materials
Semi finished goods
Finished goods
Debtors
15
15
30
100
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