Working Capital Management

Definition of Working Capital Working Capital refers to that part of the firms capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.

KINDS OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT Gross Working Capital Net Working Capital

BASIS OF TIME Permanent / Fixed WC Temporary / Variable WC Special WC

Seasonal WC Regular WC Reserve WC

Significance of Gross WC

Optimum investment in CA Investment in CA must be adequate CA investment should not be inadequate or excessive inadequate WC can disturb production and can also threaten the solvency of firm , if it fails to meet its current obligation excessive investment in CA should be avoided , since it impairs firms profitability Financing of CA Need for WC arises due to increasing level of business activity & it is to provided quickly some time surplus fund may arises which should be invested in Short term securities , they should not be kept idle

Significance of Net Working Capital

Maintaining Liquidity position For maintaining liquidity position there is a need to maintain CA sufficiently in excess of CL Judge Financial Soundness of a firm The Net working capital helps creditors and investors to judge financial soundness of a firm

BALANCE SHEET OF ABC COMPANY AS ON 31-3-2000

Liabilities Equity Shares 8% Debentures Reserve & Surplus Rs 200000 100000 50000 Assets Goodwill Land and Building Plant and Machinery Rs 20000 150000 100000 60000 40000

Sundry Creditors
Bills Payable Outstanding Expenses

150000
30000 20000

Inventories
Finished Goods Work in process

Bank Overdraft
Provision for Taxation Proposed Dividend

50000
20000 30000

Prepaid Expenses
Marketable Securities Sundry Debtors Bills Receivables Cash & Bank Balance

20000
60000 90000 20000 90000

TOTAL

650000

TOTAL

650000

Difference between permanent & temporary working capital

Amount of Working Capital

Variable Working Capital

Permanent Working Capital Time

Permanent and temporary working capital for Stable firm

Variable Working Capital Amount of Working Capital Permanent Working Capital

Time Permanent and temporary working capital for Growing firm

Operating cycle concept

Maximization of share holders wealth of a firm is possible only when there are sufficient return from the operations Successful sales activity is necessary for earning profit sales do not convert into cash immediately There is invisible time lap between the sale of good and receipt of cash The time taken to convert raw material into cash is known as operating cycle Conversion of cash into raw material Conversion of raw material into work in progress Conversion of Work in progress into finished goods Conversion of finished good into Sales ( Debtors and cash )

Raw Materials

WIP

Cash

Operating Cycle in Manufacturing firm

Finished Goods

Debtors

SALES

Operating cycle of Non Manufacturing Firm

Receivables
cash

Stock of finished goods

Formula for calculating Operating cycle for Manufacturing firm

OC = ICP+ARP OC = Operating cycle ICP = Inventory Conversion period ARP = Account Receivable Period ICP = Average Inventory Cost of good sold /365 ARP = Average Account Receivable Sales/365

ABC Company Provide the following information , Compute the operating cycle

Sales 3000 Lakhs Inventory Opening Rs 610 Lakhs ; closing Rs 475 Lakhs Receivable opening Rs 915 Lakhs; Closing Rs 975 Lakhs Cost of Goods Sold Rs 2675 Lakhs

CASH CONVERSION CYCLE The amount of time a firms resources are tied up calculated by subtracting the average payment period from the operating cycle the time period between the date a firm pays its supplier and the date it receives cash from its customer CCC = OC APP AAI = Average Inventory Cost of good sold /365 ARP = Average Account Receivable Annual Sales/365 APP = Account Payable Period Cost of good sold /365

Calculate CCC (CASH CONVERSION CYCLE) Average use of Inventory 80 days Account receivable collection period 50 days Account payable period is 40 days CCC= OC- APP OC = AAI+ARP 80+50=130 CCC =130-40 =90 days

Purchase of Raw Material On credit Average age of Inventory (AII)

Sale of Goods on Credit

Collection of Account Receivables

Account receivable period (ARP)

Account Payable Period (APP)

Payment to suppliers

Receipt of Invoice

Operating Cycle (OC)

Cash Conversion cycle

Resource flows for a manufacturing firm

Used in
Accrued Direct Labour and materials Working Capital cycle Collection process External Financing Return on Capital Accounts receivable Suppliers Of Capital Used to purchase Cash and Marketable Securities Accrued Fixed Operating expenses

Production Process Generates Inventory

Used in

Used to purchase Fixed Assets

Via Sales Generator

Calculate cash conversion cycle Sales Rs 1587.95 Cost of Good sold Rs 1406.27 Inventory opening 195.82, closing 202.29 Account receivables opening 423.03 closing 449.46 Account payable opening 140.40, closing 168.33 CCC = OC APP OC = AAI + ARP

FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTS

Factors to be considered Total costs incurred on materials, wages and overheads The length of time for which raw materials remain in stores before they are issued to production. The length of the production cycle or WIP, i.e., the time taken for conversion of RM into FG. The length of the Sales Cycle during which FG are to be kept waiting for sales. The average period of credit allowed to customers. The amount of cash required to pay day-to-day expenses of the business. The amount of cash required for advance payments if any. The average period of credit to be allowed by suppliers. Time lag in the payment of wages and other overheads

PROFORMA - WORKING CAPTIAL ESTIMATES

1. TRADING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.)

Current Assets (i) Cash (ii) Receivables ( For..Months Sales)---(iii) Stocks ( ForMonths Sales)----(iv)Advance Payments if any Less : Current Liabilities (i) Creditors (For.. Months Purchases)(ii) Lag in payment of expenses WORKING CAPITAL ( CA CL ) Add : Provision / Margin for Contingencies

--------------------_ xxx -----

NET WORKING CAPITAL REQUIRED

XXX

1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Stock of R M( for .months consumption) (ii)Work-in-progress (formonths) (a) Raw Materials (b) Direct Labour (c) Overheads (iii) Stock of Finished Goods ( for months sales) (a) Raw Materials (b) Direct Labour (c) Overheads (iv) Sundry Debtors ( for months sales) (a) Raw Materials (b) Direct Labour (c) Overheads (v) Payments in Advance (if any) (iv) Balance of Cash for daily expenses (vii)Any other item Less : Current Liabilities (i) Creditors (For.. Months Purchases) (ii) Lag in payment of expenses (iii) Any other WORKING CAPITAL ( CA CL )xxxx Add : Provision / Margin for Contingencies NET WORKING CAPITAL REQUIRED -----------------------------------------------------

----------------XXX

Prepare an estimate of Working capital requirement from the following information of a trading concern: Projected annual sales Selling price % age of Net profit on sales Average Credit Period allowed to customer Average Credit Period allowed by supplier Average stock holding in terma of sales requirement contingencies 100000 units Rs 8 per unit 25% 8 weeks 4 weeks 12 weeks 10%

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.

Prepare statement of working capital requirement, Profit &Loss A/C, Balance Sheet Assuming

Share Capital 8% Debentures Fixed asset Material Direct lab our Overheads

150000 200000 130000 40% 20% 20%

The following further particular are available It is proposed to maintain a level of activity of 2,00,000 units Selling price is Rs 12/- per unit Raw Material are expected to remain in stores for an average period of one month Material will be in process , on average half a month Finished goods are required to be in stock for an average period of one month Credit allow to debtors is two month Credit allow by supplier is one month

Working Capital Financing Mix

Approaches to Financing Mix

The Hedging or Matching Approach

The Conservative Approach

The Aggressive Approach

Hedging approach to asset financing

Total Assets Short-term Debt Fluctuating Current Assets

Permanent Current Assets

Long-term Debt + Equity Capital

Fixed Assets

Time

Hedging approach refers to a process of matching maturities of debt with the maturities of financial need . In this approach maturity of source of fund should match the nature of asset to be financed This approach is also known as matching approach. The hedging approach suggests that the permanent working capital requirement should be financed with fund from long term sources while the temporary working capital requirement should be financed with short term funds.

The Hedging approach

Estimated Total Investment in Current Asset of company X for the year 2000 Permanent or Investment Fixed Temporary in Current Asset Investments or seasonal Invest Month (R's ) (R's) (R's) January 50400 45000 5400 February 50000 45000 5000 March 48700 45000 3700 April 48000 45000 3000 May 46000 45000 1000 June 45000 45000 July 47500 45000 2500 August 48000 45000 3000 September 49500 45000 4500 October 50700 45000 5700 November 52000 45000 7000 December 48500 45000 3500 TOTAL 44300

Conservative Approach
This approach suggested that the entire estimated investments in current asset should be finance from long term source and short term should be use only for emergency requirement Distinct features of this approach Liquidity is greater Risk is minimized The cost of financing is relatively more as interest has to be paid even on seasonal requirement for the entire period

Conservative approach to asset financing

Total Assets Short-term Debt Fluctuating Current Assets

Permanent Current Assets

Long-term Debt + Equity capital

Fixed Assets

Time

Trade off between Hedging and conservative approaches

The hedging approaches implies low cost , high profit and high risk while the conservative approach leads to high cost , low profit , low risk Both the approaches are the two extreme and neither of them serve the purpose of efficient working capital management A trade off between the two will then be an acceptable approach , One way of determining the trade off is by finding the AVG of maximum and minimum requirement of current asset or working capital

Aggressive approach to asset financing

Total Assets Short-term Debt Fluctuating Current Assets

Permanent Current Assets

Long-term Debt + Equity capital

Fixed Assets

Time

Aggressive approach

The aggressive approach suggests that the entire estimated requirement of current asset should be financed from short-term sources and even a part of fixed asset investment be financed from short - term sources

This approach make the finance mix :

More Risky Less costly More Profitable

Prepare a projected balance sheet , profit and loss a/c and then an estimation of working capital . Issued Share Capital 300000 6% Debentures 200000 Fixed asset 200000 Raw Material 50% Lab our 20% Overheads 20% Profit 10% There is a regular production and sales cycle

Raw Material are kept in stores for an average period of two month Finished goods remain in stock for an average period of three month Production during the previous year was 180000 units and it is planned to maintain the same in the current year also Each unit of production is expected to be in process for half a month Credit allow to customer is three month and given by supplier is two month Selling price is Rs 4 per unit Calculation of debtors may be made at selling price

Management of Working Capital

Working capital in general practice refer to the excess of CA over CL. Management of working capital therefore is concerned with the problems that arise in attempting to manage the CA, the CL and the inter-relationship that exists between them. The basic goal of WCM is to manage the CA & CL of a firm in such a way that a satisfactory level of WC is maintained. Working Capital Management Policies of a firm have a great effect on its profitability, liquidity and structural health of the organization

Working capital management is 3 dimensional in Nature

Dimension I Profitability, Risk, & Liquidity

Working Capital Issues

Optimal Amount (Level) of Current Assets Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible
Policy A

ASSET LEVEL

Policy B Policy C

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis Policy Liquidity A High B Average C Low
Policy A

ASSET LEVEL

Policy B Policy C

Greater current asset levels generate more liquidity; all other factors held constant.

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Expected Profitability

Optimal Amount (Level) of Current Assets
Return on Investment =
ASSET LEVEL
Policy A Policy B Policy C

Net Profit Total Assets Let Current Assets = (Cash + Rec. + Inv.) Return on Investment = Net Profit Current + Fixed Assets

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Expected Profitability

Optimal Amount (Level) of Current Assets Profitability Analysis Policy Profitability A Low B Average C High
As current asset levels decline, total assets will decline and the ROI will rise.
Policy A

ASSET LEVEL

Policy B Policy C

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets

Decreasing cash reduces the firms ability to meet its financial obligations. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! Lower inventory levels increase stockouts and lost sales. More risk!

Policy A

ASSET LEVEL

Policy B Policy C

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets Risk Analysis Policy Risk A Low B Average C High
Risk increases as the level of current assets are reduced.
0 25,000 OUTPUT (units) 50,000 Policy A

ASSET LEVEL

Policy B Policy C

Current Assets

Summary of the Optimal Amount of Current Assets

SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy A B C Liquidity High Average Low Profitability Low Low Risk

Average High

Average High

1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!)

The analysis of working capital can be conducted through a number of devices such as Ratio analysis Fund flow analysis Working capital Budgeting Ratio analysis : A ratio is a simple arithmetical expression of the relationship of one number to another , this technique can be employed for measuring short term liquidity or working capital position of a firm.

Techniques of analysis of working capital

The following ratios may be calculated for this purpose

Liquidity Ratio a) Current Ratio b) Acid test ratio/quick ratio/liquid ratio c) Cash Position ratio/absolute liquid ratio Inventory turnover ratio Receivable turnover ratio Payable turnover ratio Working capital turnover ratio

 Current

ratio may be define as the relationship between CA and CL This ratio is also known as WCR. (Working capital ration). It is helpful to measure short term financial position or liquidity of a firm Current ratio: Current asset Current liabilities

CURRENT ASSETS Cash in hand Cash at bank Sundry Debtors Marketable securities (Short term)

CURRENT LIABILITIES

Bills Payable Sundry Creditors Accrued or Outstanding Expenses

Short term loan and advances

Bills Receivable Inventories of Stock Work in progress Finished goods Prepaid Expenses

Dividend payable Bank Overdraft

Quick or Acid test or Liquid Ratio

An asset is said to be liquid if it can be convert into cash with in a short period with out loss of value Inventory cannot be termed to be liquid asset because they cannot be convert into cash immediately The quick ratio can be calculated Quick ratio: liquid asset Current liabilities

Quick or liquid Cash in hand

Cash at bank Sundry Debtors Marketable securities Temporary Investments

Current Liabilities Bills Payable

Sundry Creditors Accrued or Outstanding Expenses Short term advances Dividend payable Bank Overdraft Income tax payable

Convection quick ratio of 1:1 is consider satisfactory

Cash Position ratio/absolute liquid ratio

Absolute Liquid assets include cash in hand and cash at bank and marketable securities or temporary investments The acceptable norms for this ratio is 50% or .05% Cash ratio: Cash & bank + Short term securities Current liabilities

Calculate all the three ratio

Liabilities 9% preference share Equity share capital 8% debentures Long term loan Bills payable Sundry creditors Bank over draft Outstanding expenses Rs Assets 500000 Goodwill 1000000 Land and building 200000 Plant Furniture and 100000 fixtures 60000 Bills receivable 70000 Sundry debtors 30000 Bank balance short term 5000 investments Prepaid expenses Stock Rs 100000 650000 800000 150000 70000 90000 45000 25000 5000 30000

1965000

1965000

CONCLUSION:
Current

ratio of the company is not satisfactory because the ratio 1:6 is much below then the expected Standards . Acid test ratio on the other hand is more than the normal standard of 1:1 Absolute ratio is slightly low because it is 0.42 where as the accepted standard is 0.5 In this company need to improve its short term financial position

Inventory turnover ratio

Inventory turn over ratio = Cost of good sold Average Inventory at cost Generally , the cost of good sold may not be known from the published financials , in such circumstances Inventory turn over ratio = Net Sales Average Inventory at cost Inventory turn over ratio = Cost of good sold Average Inventory at selling price

Inventory conversion period

Inventory conversion period = Days in a year Inventory Turnover Ratio M/s Rakesh & Co supplies you the following information for the year ending 31st Dec 1999 Credit Sales Rs 150000 Cash Sales Rs 250000 Return Inward Rs 25000 Opening Stock Rs 25000 Closing Stock Rs 35000

Debtor(Receivable) = Net credit Annual sales Average Trade debtors Trade debtors = Sundry debtor + Bill Receivable and account receivable s Average Trade Debtors = Opening Trade debtor + Closing Trade Debtor /2 Note : Debtor should always be taken at gross value , No provision for doubtful debt be deducted from them but when the information about opening and closing balance of trade debtor and credit sales is not available , then the debtors turnover ratio calculated by dividing the total sales by the balance of debtors(inclusive of Bills receivables) given Debtors turn over Ratio = Total sales Debtors

Debtor/Receivable turnover ratio /Debtor velocity

Average Collection Period

The average collection period represent the average number of days for which a firm has to wait before its receivable are converted into cash Average Collection period = Average Trade Debtors (Drs + B/R) Sales per day Sales Per day = Net Sales No of working days

Or Average collection period =Average trade debtors Net Sales No of working days If the period is in months: Average collection period =No of working days Debtors turnover ratio The two basis component of the ratio are debtors and sales per day

Creditor/Payable turnover ratio

The analysis for credit turnover is basically the same as of debtors turnover ratio except that in place of trade debtor, the trade creditor are taken and in place of sales , average daily purchase are taken as the other component of the ratio. Creditors turnover ratio = Net credit annual purchase Average Trade creditors

Average Payment period Ratio = Average Trade Creditors( Creditors+ Bills payable)/Average Daily purchases. Average daily purchase = Annual Purchase /No of working days in a year. Average Payment Period = Trade creditor * No of working days / Net annual purchase. Average Payment Period = No of working days / Credit turnover Ratio.

Working capital turnover ratio

Working capital of a concern is directly related to sales and current asset like debtors , bills receivable , cash , stock etc . Working capital turnover ratio = Cost of Sales / Average working capital Average working capital = Opening working capital + Closing Working capital/2 ** If cost of sales is not given , then the figure of sale can be used . O n the other hand if opening working capital is not disclosed then working capital at the end of the year will be used.

The following information is given about M/s S.P Ltd for the year ending Dec 31 2000 Stock turnover ratio = 6times Gross Profit ratio = 20% on sales Sales for 2000 = Rs 300000 Closing stock is Rs 10000 more than the opening stock Opening Creditors = Rs 20000 Closing Creditors = Rs 30000 Trade debtor at the end = Rs 60000 Net Working Capital = Rs 50000

 FIND

OUT Average Stock Purchases Credit turnover ratio Average Payment Period Average Collection Period Working Capital turnover ratio

Fund flow analysis : Fund flow analysis is a

technical device designated to study the sources from which additional fund were derived and the use to which these sources were put . It is an effective management tool to study change in the financial position of business

The fund flow analysis consists of

Preparing schedule of change in working capital Statement of sources and application of funds

 Working

capital Budgeting : Working capital budget as a part of total budgeting process of a business , is prepared estimating future long term and short term working capital need and the sources of finance them . The objective of a working capital budget is to ensure availability of fund as and when needed and to ensure effective utilization of these resources .