Working Capital Management
Working Capital Management
WORKING CAPITAL MANAGEMENTINTRODUCTION TO FINANCE:
Finance is a field closely related to accounting that deals with
the allocation of assets and liabilities over time under conditions
of certainty and uncertainty. Finance also applies and uses the
theories of economics at some level. Finance can also be defined as
the science of money management. A key point in finance is the time
value of money, which states that purchasing power of one unit of
currency can vary over time. Finance aims to price assets based on
their risk level and their expected rate of return. Finance can be
broken into three different sub-categories: public finance,
corporate finance and personal finance.
Questions in personal finance revolve around
Protection against unforeseen personal events, as well as events
in the wider economy
Transference of family across generations bequests and
inheritance
Effects of tax policies tax subsidies and/or penalties on
management of personal finances
Effects of credit on individual financial standing
Planning a secure financial future in an environment of economic
instability
Personal finance may involve paying for education, financing
durable goods such as real estate and cars, buying insurance, e.g.
health and property insurance, investing and saving for
retirement.
Personal finance may also involve paying for a loan, or debt
obligations. The six key areas of personal financial planning, as
suggested by the Financial Planning Standards Board, are:[1]1.
Financial position: is concerned with understanding the personal
resources available by examining net worth and household cash flow.
Net worth is a person's balance sheet, calculated by adding up all
assets under that person's control, minus all liabilities of the
household, at one point in time. Household cash flow totals up all
the expected sources of income within a year, minus all expected
expenses within the same year. From this analysis, the financial
planner can determine to what degree and in what time the personal
goals can be accomplished.
2. Adequate protection: the analysis of how to protect a
household from unforeseen risks. These risks can be divided into
liability, property, death, disability, health and long term care.
Some of these risks may be self-insurable, while most will require
the purchase of an insurance contract. Determining how much
insurance to get, at the most cost effective terms requires
knowledge of the market for personal insurance. Business owners,
professionals, athletes and entertainers require specialized
insurance professionals to adequately protect themselves. Since
insurance also enjoys some tax benefits, utilizing insurance
investment products may be a critical piece of the overall
investment planning.
3. Tax planning: typically the income tax is the single largest
expense in a household. Managing taxes is not a question of if you
will pay taxes, but when and how much. Government gives many
incentives in the form of tax deductions and credits, which can be
used to reduce the lifetime tax burden. Most modern governments use
a progressive tax. Typically, as one's income grows, a higher
marginal rate of tax must be paid. Understanding how to take
advantage of the myriad tax breaks when planning one's personal
finances can make a significant impact.
4. Investment and accumulation goals: planning how to accumulate
enough money - for large purchases and life events - is what most
people consider to be financial planning. Major reasons to
accumulate assets include, purchasing a house or car, starting a
business, paying for education expenses, and saving for retirement.
Achieving these goals requires projecting what they will cost, and
when you need to withdraw funds. A major risk to the household in
achieving their accumulation goal is the rate of price increases
over time, or inflation. Using net present value calculators, the
financial planner will suggest a combination of asset earmarking
and regular savings to be invested in a variety of investments. In
order to overcome the rate of inflation, the investment portfolio
has to get a higher rate of return, which typically will subject
the portfolio to a number of risks. Managing these portfolio risks
is most often accomplished using asset allocation, which seeks to
diversify investment risk and opportunity. This asset allocation
will prescribe a percentage allocation to be invested in stocks,
bonds, cash and alternative investments. The allocation should also
take into consideration the personal risk profile of every
investor, since risk attitudes vary from person to person.
5. Retirement planning is the process of understanding how much
it costs to live at retirement, and coming up with a plan to
distribute assets to meet any income shortfall. Methods for
retirement plan include taking advantage of government allowed
structures to manage tax liability including: individual (IRA)
structures, or employer sponsored retirement plans.
6. Estate planning involves planning for the disposition of
one's assets after death. Typically, there is a tax due to the
state or federal government at one's death. Avoiding these taxes
means that more of one's assets will be distributed to one's heirs.
One can leave one's assets to family, friends or charitable
groups.
INTRODUCTION TO WORKING CAPITALWorking capital is the firms
holding of current assets such as cash, receivables, inventory and
marketable securities. every firm required working capital for its
day to day transaction such as purchasing raw material , for
meeting salaries , wages rents rates ,advertising etc.., but there
is much disagreement among various financial authorities (financial
manager , accountants ,businessmen and economists)as to the exact
meaning of the term working capital .
Defining Working Capital
1.Working capital is excess of current assets over current
liabilities.
Guthmann&Dougall
2.Working capital refers to a firms investment in short term
assets, cash, short term securities, account receivables and
inventories.Weston & Beigham
3.Working capital is the amount of funds necessary to cover the
cost of operating the enterprise. Shubin
Objectives of Working capital Management:
The Objectives of Working capital Management are two fold:
1. Maintenance of Working capital and
2. Ability of ample funds at the time of need.
The basic goal of Working capital management is to manage each
of the funds current assets and current liabilities in such a way
that an acceptable level of networking capital is always maintained
in the business.
Scope of Financial Management: The Scope of Financial Manager is
divided into two broad categories.
(A). Traditional Approach: The Scope of Finance function was
treated by the traditional approach in the narrow sense of
procurement of finds by corporate to meet their financing
needs.
(B).Modern Approach: The modern approach views financial
management in a broad sense and provide a conceptual and analytical
frame work for finance function covers both acquisitions of funds
as well as their allocation.
Significance of working capital:
The world in which real firms function is not perfect. It is
characterizes by the firms considerable uncertainty regarding the
demand, markets price, quality circumstances introduce problems to
the firm must deal. While the firm has many strategies available to
address these circumstances, strategies that utilize investment or
financing with working capital accounts often offer a substantial
advantage over the other techniques. The importance of working
capital management is reflected in the fact that financial managers
spend a great deal of time in managing current assets and current
liabilities like
Arranging short term financing:
Negotiating favorable credit terms
Controlling the movement of cash
Administering accounts receivables
Monitoring investment in receivables
Decisions concerning the above areas ply an important role in
maximizing overall value of the firm. Once decisions concerning
these areas are reached, the level of working capital is also
determined in active decision sense, but falls out as residual from
the decision just made.
The management of working capital plays an important role in
maintaining the financial health during the normal course of
business. This critical role can be enunciated by examining the
flow of resources thorough the firm. By far the major flow is the
working capital cycle. Working capital.
Financial Management Process:
FINANCIAL DECISIONS: Financial decision is three types
Market Price of the Share: Share Holder Wealth
(WO=Npo)1.Investment Decisions:
It is broadly concerned with the investment of assets. The main
idea is maximization of owners wealth. Decision is taken to
maximize the benefits of equity shareholders.
2. Financial decisionThe major second decision of the firm is
the financing decision. Here, the financial manager is concerned
with determining the best financing mix or capital structure for
his firm. The management will decide how many funds should be
provided from outside public and financial institutions.
3. Dividend decision:
The top management decides how much is retained and distributed
to equity share holders. These earnings are called earnings
available to equity shareholders.
Determinants of working capital:
A large number of factors influence the net working needs of the
firm. These factors affect different enterprises differently. They
vary from time to time. In general the following factors are
involved in a proper assessment of working capital required.
1. Nature and Size of Business:Working capital requirements of a
firm are basically influenced by the nature of its business.
Trading and financial firms have a very less investment in fixed
assets but require a large sum of money to be invested in working
capital. In contrast public utilities have a very limited need for
working capital and have to invest abundantly in fixed assets. The
working capital needs most manufacturing concerns fall between two
extreme requirements of trading and public utilities.
The size of business also has an impact on its working capital
needs. Size may be measured in terms of the scale of operation. A
firm with larger scale of operation will need more working capital
than a small firm.
2. Manufacturing Cycle:The manufacturing cycle starts with the
purchase of raw materials and completes with production of finished
goods. Longer the manufacturing cycle, larger is the tied up of
funds in inventories. Thus if there are alternative ways of larger
is the tied up of funds in inventories. Thus if there are
alternative ways of manufacturing product, The Process with the
shortest manufacturing cycle must be chosen.
3. Business Fluctuation:
Business variations effect especially the temporary working
capital requirement. When there is an upward swing in the economy
sales wills increase correspondingly the firms investment in
inventories and book debts will also increase. On the other hand
when there is a decline in the economy, sales will fall and
consequently levels of inventories and book debt will also
fall.
4. Production Policy:A strategy of constant production may be
maintained in order to resolve the working capital problems arising
due to seasonal changes in the demand for the firms capital. A
steady production policy will cause inventories to accumulating
during the off-season periods and the firm will be exposed to
greater inventory costs and risks. The firm may then adopt the
policy of varying its production schedules in accordance with
changing demand.
5. Firms Credit Policy:The credit policy of the firm affects
working capital by influencing the level of book debts. The credit
terms to be granted to customers may depend upon norms of the
industry to which the firms belong. A high collection period will
mean tie up of funds in book debts.
6. Availability of Credit:The credit terms granted by the firms
creditors also effect the working capital requirements of a firm,
which creditors also effect the working capital requirements of a
firm. A firm which can get bank credit easily on favorable
conditions will operate with less working capital than a firm with
out such a facility.
7. Growth and Expansion Activities:A growing firm may need to
invest funds in fixed assets in order to sustain its growing
production and sales. This will in turn increase investment in
current assets to support enlarged scale of operations. It should
therefore make proper planning to finance the increasing needs for
working capital.
8. Price Level Changes In Raw Material And Finished Goods:
Rising price levels require a firm to maintain higher working
capital; same level of current assets will require products prices
with rising price levels so that they do not face a serve working
capital problem.9. Profit Margin And Appropriation:A high net
profit is a source of working capital to the extent; it has been
earned cash. The cash profit is found by adjusting non-cash items
such as depreciation outstanding expenses, accumulated expenses and
losses written off in the net profit. It contribution working
capital would be affected by the way in which profit are
appropriated .Higher the amount of dividends less will be the
contribution towards working capital funds, the availability of
cash generated from operation thus depends upon taxation, dividend
and retention policy and depreciation policy.
10. Operating Efficiency:
The operating efficiency of the firm relates to the optimum
utilization resources costs. The firm will be effectively
contributing to its working capital if it is efficient in
controlling operating costs. The use of working is improved and
pace of cash cycle is accelerated with operating efficiency.
SOURCES OF WORKING CAPITAL:
After determining the level of working capital on the basis of
various determinants the next step is to consider how it will be
financed. A large manufacturing concern may procure funds from
various sources to meet its working capital requirement s from time
to time. For the convenience of study the sources of working
capital may be classified under twos heads.
a) Sources of long term or regular working capital
b) Sources of short term or seasonal working capital
Sources of long term working capital:
The long-term working capital requirements can be met from the
following sources.
1. Issue of Shares:
It is the safest way of producing permanent and regular working
capital with out any fixed charges.
2. Issue of Debentures: Regular and long term working capital
may be obtained at lower cost of trade on equity.
3. Retained profits: Accumulated large profits are also
considered to be good sources of financing long-term working
capital requirements. It is the best and the cheapest source of
finance. It creates no change in future profits.
4. Sale of fixed assets:
If there is any idle fixed assets in the firm can be sold out
and the proceeds may be utilized for financing the working capital
requirements.
5. Term loans:
Mid term and long-term loans for a period above 3 years provide
import sources of working capital such term loans can be borrowed
from the special financial institutions such as IDBI, IFSI, and LIC
etc.
Sources of short term working capital:
The sources of short term working capital may be classified in
two heads
1. Internal sources
2. External sources
Internal sources:
Under this category the sources of working capital are tapped
from within the internal sources are depreciation funds, provision
for taxation and accrued expenses.
1. Depreciation fund:
Depreciation funds created out of profits provided they are
invested in or represented by assets
2. Provision for taxation:
There remains a time lag between making the provision for and
payment of taxation. A company may utilize such provision during
the intermittent period temporarily.
3. Bank credit:
The greater part of the working capital is supplied by
commercial banks to their customers through direct advances in the
shape of loans, cash credit or over draft and thorough discounting
the credit, papers, e.g. billpayable and promissory
4. Customer credit:
Advance may also be obtained form customers against the
contracts entered into by the enterprise such advances are
generally asked for, by the Companies manufacturing large plants
and machinery involving longer time in completing the process of
manufacturing e.g., ship building industries. The amount can be
used for purchasing raw materials, paying wages and so on.
5. Public deposits:
Most of the companies in recent years depend on this source to
meet their working capital requirements. Under the companies Act
1956 a company is authorized to raise funds equal to 25% paid up
capital and free reserves by this source.
6. Government assistance:
Central and state Governments of the country provide short-term
finance to industries or business by allowing tax concessions,
sanctioning direct loans or grants to industries or a class of
industries to assist their production programs etc.
Standards of working capital management:
I. There is no one single criteria for judging the efficient
arrangement of working capital.
Factors to be taken into account for organizing on efficient
lines:
Ability to meet short term commitments in time, make payment of
bills on due dates.
Ability to find adequate cash at the right time to present
forecast levels of business.
Ability to maximize sales turnover with minimum possible
cash.
Minimum possible inventory Turnover Turnover norms are
fixed.
Whether reasonable credit is extended to customers as a sales
and monitoring strategy.
Financing plans are prepared in anticipation of future need so
that funds become available at the right time and at least
cost.
Policies for credit to present and new customers are prepared
and forecast of collections of receivables are hole along with
forecast of sales.
Norms are laid down for average age of receivables, collection
period.
Proportion of goods in process and finished goods to new orders
and dispatches.
Proportion of raw materials, goods in process, and finished
goods to total inventories are established and operated.
Ratio to measure the efficiency of working capital.
Current Ratio: Current assets/Current liabilities
Quick Ratio : (Current assets-inventories)/current
liabilities
Sales to Cash: Sales during a period / Average cash balance
Average collection period: Debtors divided by annual credit
sales and the resulting figure multiplied by 365. This ratio
indicates how many days of credit are being obtained from the
suppliers.
Average payment period: Creditors divided by annual credit
purchase and the resultant figure is multiplied by 365. This ratio
indicates how many days of credit are being obtained from the
suppliers.
Inventory turnover ratio: Sales/Average Inventory.
Working capital cycle
This is the loop which starts at the cash and the marketable
securities account, goes trough the current account as direct
labour and materials which are purchased and use to produce
inventory, which in turn is sold and generates accounts
receivables, which are finally collected to replenish cash. The
major point to notice about this cycle is that the turnover or
velocity of resources through this loop is very high related to the
other inflow s and outflows of the cash account.
Concept of working capital:
There are two concepts of working capital
Gross Working Capital
Net Working Capital
Gross Working Capital:
Gross working capital, simply called as working capital refers
to the firms investment in current assets, which in ordinary course
of business can be converted into cash within an accounting
year.
Examples of Current Assets are:
Cash and bank balances
Short term loans and advances
Bills Receivables
Sundry Debtors
Inventory
Prepaid Expenses
Accrued Incomes
Money Receivable in 12 months
Gross working capital focuses attention of two aspects of
current assets management.
a) Optimum investment in current assets and
b) Financing of current assets.
The Consideration of the level of investment in current assets
should avoid two danger points excessive and inadequate investment
in current arranging funds to finance arises due to the increasing
level of business activity or for any other reason arrangement
should be made quickly.
Net Working Capital:
Net working capital refers to the difference between the current
assets and current liabilities. Current liabilities are those
claims of outsiders, which are accepted, to mature for payment with
an accounting year and include creditors, bills payable and
outstanding expenses.
Net Working Capital = Current Assets-Current Liabilities
Net working capital can be positive or negative. A positive net
working capital will arise when current assets exceeds current
liabilities. It is a quantitative concept. I
a) Indicate the liquidity position of the firm and
b) Suggests the extent to which working capital needs may be
financed by permanent sources of funds.
Types of Working Capital:
Working capital can be classified into two categories i.e.
1. Permanent working capital
2. Temporary or variable working capital
Permanent Working Capital:
It is the minimum amount of investment in all current assets
which is required at all times to carry out minimum level of
business activities. Tendon Committee has reserved to this type of
working capital as Core Current Assets.
Characteristics of permanent working capital:
Amount of permanent working capital remains in the business in
one form or another.
It also grows the size of the business. It should be financed
out of long term funds.
Variable working capital:
The amount of working capital over permanent working capital is
known as variable working capital. The amount of such working
capital keeps on fluctuating form time to time on the business
activities. It may again be subdivided into seasonal working
capital and special working capital. Seasonal working capital is
required to meet the seasonal demands of busy periods occurring at
started intervals on the other hand, special working capital is
required to meet extraordinary need for contingencies. Even like
strikes, fire unexpected competition; rising price tendencies or
initiating a big advertisement campaign require such capital.
The Need for Working Capital:
Every business needs some amount of working capital. The need
for working capital arises due to the gap between production and
realization of cash from sales.The following are the needs of
working capital: To pay wages and salaries
To incur day to-day expenses and over heads.
To meet the selling costs.
To provide credit facilities to the customers.
Some of the Important Terms
1. Gross Working Capital =Total Current Assets.
2. Net Working Capital = Current Assets Current Liabilities.
Operating cycle
There is an Operating Cycle involve in the conversion of sales
into cash. Operating cycle is the time duration required to convert
sales, after the conversion of resources into cash. The duration of
time required to complete the following sequence of events is the
operating cycle for a manufacturing firm is as follows.
ASSEMENT:
In order to find out the total working capital requirements of a
firm, the needs at each of the following 4 stages have to be
calculated.
STAGE ITEMTIMEVALUE
1.RAW MATERIALLead time consumption storage period.Value of
consumed raw material, The valuations to be down at a cost or price
whichever is lower.
2.STOCK IN PROCESSTime taken to convert the raw material,
finished goods.Raw Material to all expenses at cost price.
3.FINISHED GOODSAverage period for which finished goods are kept
storage before they are actual sold.-do-
4.RECEIVABLESCredit period allowed by the unit of
buyers.Receivables at cost.
OTHER FACTORS:
Non- coordination of production and distribution cycle.
Menace of transport and communication not all developed enhances
cost.
Impact of government policies etc.
WORKING CAPITAL FORECAST:
There are number of methods to determine the Working capital
needs.
1. By determining the amount of current assets and current
liabilities:
The assessment of Working capital requirements can be made on
the basis of the current assets required for the business and the
credit facilities available for the acquisition of such current
assets from the current liabilities.
2. Cash forecasting methods:
In this method the position of cash at the end of the period is
shown after considering the receipts and payments to be made during
the period. Its form assumes more or less a summary of cashbook.
This shows the deficiency or surplus of cash as the definite point
time.
3. The Balance sheet Method:
The balance sheet method of forecast is made up of the various
assets and liabilities of the business. Afterwards, the difference
between the two is taken which will indicate cash surplus or
deficiency.
4. Profit and Loss adjustment method:
Under this method the forecast profits are adjusted after adding
the cash inflows and deducting the cash outflows. The basic idea
under this method is to adjust the estimated profit on cash
basis.
5. Working capital as a percent of sales:
Under this method the Working capital is to be related to sales
and calculated as a percentage of sales.6. Working capital as
percentages of fixed assets:In this method Working capital is
related to fixed capital investment. Therefore, it is projected as
a percentage of fixed capital investment.
Advantages of adequate working capital:
A business firm maintains an adequate level of working capital
in order to run its business smoothly. It is worth y to note that
both excessive and inadequate working capital positions are harmful
.out of two, inadequacy of working capital is more dangerous for a
firm .excessive working capital result in idle funds on which no
profit is earned .similarly insufficiency of working capital result
in interruptions of production. This will lead to inefficiencies,
increase in costs and reduction in profits .working capital is just
like the lifeblood of business. If it becomes weak, the business
can hardly prosper and survive .no business can run successfully
without an adequate amount of working capital. The following are
few advantages of adequate working capital in the business.
Cash discount :
Adequate working capital enables a firm to avail cash discount
facilities are offered to it by the suppliers. The amount of cash
discount reduces the cost of purchase.
Goodwill :
Adequate working capital enables a firm to make prompt payment.
Making prompt payment is a base to create and maintain good
will.
Ability to face crisis:
The provision of adequate working capital facilities to meet
situations of crisis and emergencies. It enables a business to
withstand periods to depression smoothly.
Credit-worthiness:
It enables a firm to operate its business more efficiently
because there is no delay in getting loans from banks and others on
easy and favorable terms.
Regular supply of raw materials :
It permits the carrying of inventories at a level that would
enable a business to satisfactory the needs of its customers. That
is it ensures supply of raw material and continuous production.
Expansion of markets :
A firm, which has adequate working capital, can create favorable
market condition. That is purchasing its requirements in bulk when
prices are lower and holding its inventories for higher.
Productivity increased Profits are increased.
Productivity increased
Research programs
Problems of inadequate working capital:
It may not able to take advantage of profitable business
opportunities.
Production facilities cannot be utilized fully
Short-term liabilities cannot be paid because of lack of working
capital
It may fail to pay its dividend because of non-availability of
funds
Its low liquidity may lead to low profitability .in the same way
,low profitability results in low liquidity
It may not be able to take advantages of cash discounts
Credit worthless of the firm may be damaged because of lack of
liquidity .thus it may lose reputation; thereafter a firm may not
be able to get credit facilities.
Danger of excessive working capital:
A firm may tempted to over trade and lose heavily
Unable to extract benefits of customer credit
The situation may lead to unnecessary purchases and accumulation
of inventories. This cause more chances of theft, waste, losses
etc.
There arises an imbalance between liquidity and
profitability.
Excessive working capital means funds are idle.
The situation leads to greater production, which may not be
having matching demand
The excess of working capital leads to carelessness about cost
of production.
CONCLUSION:In my point of view working capital with cash from
operations and short-term borrowings when necessary. Various assets
and liabilities, including short-term debt, can fluctuate
significantly from month to month depending on short-term liquidity
needs. As a result, working capital is a prime focus of management
attention.
Used to purchase
Accounts receivables
Supplies of capital
Fixed assets
Inventory
Accrued direct labour and material
Accrued fixed operating expenses
Production process generates
Cash & marketable securities
Via sales generates
Collection process external functioning
Return to capital
KECW::NRT21