WORKING CAPITAL MANAGEMENT

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 and inventories.

Concepts of Working capital

Gross working capital (GWC)
GWC is the capital invested in the total current assets of the enterprise.

Net working capital (NWC)

NWC is the excess of current assets over the current liabilities NWC = CA-CL

Classification or Kinds of Working Capital

A. On the basis of concept
Gross working capital Net working capital

B. On the basis of time

Permanent or fixed working capital
(i) Regular working capital (ii) Reserve working capital

Temporary or variable working capital

(i) Seasonal working capital (ii) Special working capital

Importance/ Advantages of working capital

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Solvency of the business Goodwill Easy loans Cash discounts Regular supply of raw material Regular payment of day to day commitments Exploitation of favourable market opportunities Ability to face crises Quick and regular return on investments High morals

Disadvantages of excess working capital

1. Idle funds which earns no profits 2. Unnecessary purchasing and accumulation of inventories 3. Excessive debtors and defective credit policy 4. Overall inefficiency in the organization 5. Spoiled relations with banks and FIs 6. Low rate of return and fall in the value of share 7. Gives rise to speculative transactions

Disadvantages of inadequate working capital

1. Cannot pay short term obligations in time. 2. Cannot buy requirements in bulk and cannot avail discounts. 3. Difficult to exploit favourable market opportunities. 4. Cannot pay day to day expenses. 5. Creates inefficiencies, increase costs and reduces profitability. 6. Cannot utilize the fixed assets efficiently. 7. Rate of return on investment falls.

Need/ Objectives of Working capital

1. For purchase of raw materials, components and spares. 2. To pay wages and salaries. 3. To incur day to day expenses and overheads like fuel, power etc. 4. To meet the selling costs. 5. To provide credit facilities. 6. To maintain the inventories of RM, WIP, stores and spares and FG.

Factors determining working capital requirements

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Nature or character of business Size of Business/Scale of operations Production policy Manufacturing Process/ length of the production cycle Seasonal Variations Working capital cycle Rate of stock turnover Credit policy Business Cycle Rate of Growth of business Earning capacity and dividend policy Price level changes Other factors

Operating Cycle
It is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases: 1. Acquisition of resources such as raw material, labour, power and fuel, etc. 2. Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. 3. Sale of the product either for cash or on credit. Credit sales create account receivable for collection.

How the length of operating cycle determined?

The length of operating cycle of a manufacturing firm is the sum of: 1. Inventory conversion period (ICP) and 2. Debtors (receivable) conversion period (DCP) The inventory conversion period is the total time needed for producing and selling the product. It includes: a) Raw material conversion period (RMCP) b) Work-in-process conversion period (WIPCP) c) Finished goods conversion period (FGCP)

 The debtors conversion period is the time required to collect the outstanding amount from the customers. The total of inventory conversion period and debtors conversion period is referred to as Gross Operating Cycle (GOC). GOC = ICP + DCP ICP = RMCP + WIPCP + FGCP

Raw material conversion period

it is the average time period taken to convert material into work-in-process. The formula is: RMCP = RMI * 360 RMC

Work-in-process conversion period

it is the average time taken to complete the semi-finished or work-in-process. The formula is: WIPCP = WIPI * 360 COP Where, WIPI is work-in-process inventory, COP is cost of production

Finished goods conversion period

It is the average time taken to sell the finished goods. The formula is: FGCP = FGI * 360 CGS Where, FGI is finished goods inventory CGS is cost of goods sold

Debtors (receivable) conversion period

It is the average time taken to convert debtors into cash. DCP represents the average collection period. It is calculated as: DCP = Debtors * 360 Credit sales

Creditors (payables) deferral period (CDP)

It is the average time taken by the firm in paying its suppliers (creditors). The formula is: CDP = Creditors * 360 Credit purchases

Cash Conversion or Net Conversion Period (NOC) NOC is the difference between gross operating cycle and payables deferral period. NOC = GOC CDP NOC is also referred to as cash conversion cycle.

Estimating the working capital requirements

Factors requiring consideration while estimating working capital: Total cost incurred on material, wages and overheads. The length of the time for which raw materials are to remain in stores before they are issued for production. The length of the production cycle The length of the sales cycle Average credit period allowed to the customers Cash required for day to day operations Cash required for advance payments Credit period expected from the suppliers Time lag in the payment of wages and other expenses

Statement of Working Capital Requirement

Particulars Amount (Rs.)

Current Assets:
Cash Debtors Stock Advance payments Others **** **** **** **** **** **** ****

Less: Current Liabilities:

Creditors Lag in payment of expenses (outstanding expenses)

Working Capital (C.A. C.L.) Add: Provisions for contingencies Net Working Capital Required

****
****

****

Example: Estimate the working capital requirements from the following information: Cost of sales = Rs. 6,00,000 Average credit period allowed to customers = 8 weeks Average credit period allowed by suppliers = 4 weeks Average stock holding in terms of sales requirement = 12 weeks Allow 10% for contingencies.

Financing of working capital needs Sources of working capital

A. Permanent Sources
Shares Debentures Public Deposits Loans from Financial Institutions

B. Temporary Sources
Trade credit Accrued expenses Deferred Income Commercial papers Factoring Commercial banks

1. Trade Credit
It refers to the credit that the customer gets from the supplier of goods in the normal course of business. In this, no cash is paid immediately to the supplier for the purchase of goods. It is an informal arrangement between the buyer and the supplier. Trade credit is based on the credit terms.

Credit Terms:
Credit terms are the conditions under which the supplier extends credit to the buyer and the buyer is required to repay the credit. These conditions include the due date and the cash discount given for prompt payment.

 Due date: is the date by which the supplier expects payment. Cash discount: is the concession offered to the buyer by the supplier to encourage him to make payment promptly. Credit terms indicate the length and beginning date of the credit period.

 The typical way of expressing credit terms is, 2/10, net 30. This implies that a 2% discount is available if the credit is repaid on the 10th day, and in case the discount is not taken, the payment is due by the 30th day.

Benefits of Trade Credit: Easy availability Flexibility Informality or less formalities involved.

2. Accrued Expenses
It is a spontaneous source of short-term financing. Accrued expenses represent a liability that a firm has to pay for the services which it has already received. They represent a spontaneous, interest-free sources of financing. The most important components of accruals are wages and salaries, taxes and interest.

 Accrued wages and salaries: represent obligations payable by the firm to its employees. The firm incurs a liability the moment employees have rendered services. They are paid afterwards, usually at some fixed interval like one month.

 Accrued taxes and interest: Corporate taxes are paid after the firm has earned profits. These taxes are paid quarterly during the year in which profits are earned. This is a deferred payment of the firms obligation and thus, is a source of finance. Like taxes, interest is paid periodically during a year while the firm continuously uses the borrowed funds. Thus accrued interest on borrowed funds requiring semi-annual interest payments can be used as a source of financing.

3. Deferred Income
It is also one of the spontaneous sources of short-term financing. It represents funds received by the firm for goods and services which it has agreed to supply in future.

4. Commercial Paper
It is a short-term unsecured promissory note with a fixed maturity period, issued by financial and non-financial companies with high credit rating. In India, the RBI regulates the issue of commercial papers. Those companies are allowed to issue commercial papers which have a networth of Rs 10 crore, i.e. Rs 100 million and are listed on the stock exchange.

 The size of each commercial paper should not be less than Rs 5 lakh. Only high credit rating companies can go for commercial papers. Ratings are given by various credit rating agencies such as CRISIL, ICRA, and CARE. The participants of commercial papers can be corporate bodies, banks, mutual funds, LIC, UTI, GIC, etc.

5. Factoring
A factor is a financial institution who takes the responsibility of financing and collecting debts that may arise out of credit sales. Factoring is an arrangement between the factor and his client (seller) which includes atleast two of the following services to be provided by the factor: Finance Maintenance of accounts Collection of debts Protection against credit risk

6. Commercial banks
Overdraft: the borrower is allowed to withdraw funds in excess of the balance in his current account up to a certain limit during a stipulated period. Cash credit: a borrower is allowed to withdraw funds from the bank up to the sanctioned credit limit. Purchase or discounting of bills: a borrower can obtain credit from a bank against its bills.

 Letter of credit: suppliers, particularly the foreign suppliers, insist that the buyer should ensure that his bank will make the payment if he fails to honour its obligation. This is ensured through a letter of credit. A bank opens an L/C in favour of a customer to facilitate his purchase of goods. If the customer does not pay to the supplier within the credit period, the bank makes the payment under the L/C arrangement.

Security required in bank finance

Hypothecation: the borrower is provided with working capital finance by the bank against the security of movable property. Pledge: the borrower is required to transfer the physical possession of the property offered as a security to the bank to obtain credit. Mortgage: is the transfer of a legal or equitable interest in a specific immovable property for the payment of a debt.