WORKING CAPITAL MANAGEMENT

Working Capital ?
Working Capital
Assets and liabilities required to operate a business on a day-to-day basis

Assets:
Cash Accounts Receivable Inventory

Liabilities:
Accounts Payable Accruals

Working capital decisions are of tremendous importance for any firm

The mismanagement related to current operations is the leading cause of business failure. - Ralph Kennedy and Steward Mc Mullar

Learning Points
Concept of Working Capital Factors Influencing Working Capital Requirements Operating Cycle Analysis

Meaning of Working Capital

Working capital is the investment made by firms in their current assets. Current assets comprise all assets that the firm expects to convert into cash within the year. This includes
Cash and bank balance (already in cash form), Marketable securities, Accounts receivable, and Inventories.

Gross and Net Working Capital

Gross working capital (GWC) is defined as investment in current assets. Net working capital (NWC) is defined as excess of current assets over current liabilities.

Managers Concern is more on

Gross working capital Or Net Working Capital ?

Both concepts (GWC and NWC) are equally important in the management of working capital, as both are related. One is a measure of the level of current assets while the other measures the extent to which longterm sources of financing have been used to finance current assets.

Negative Working Capital

Negative working capital emerges when current liabilities exceed current assets. Such a situation is not absolutely theoretical, and occurs when a firm is nearing a crisis of some magnitude.

Features of Working Capital Decisions

Working capital decisions are typically Shortterm financial decisions The concepts of risk and time value of money are less pertinent to working capital decisionmaking.

Working Capital Elements Working capital elements are: Inventory Management Receivables Management Cash Management

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Objective of WCM
The objective of WCM is to run the firm with as little money tied up in the current accounts as possible

Befits and cost of high and low levels of working capital

Inventory
High Levels
Benefit: Happy customers Few production delays (always have needed parts on hand) Cost: Expensive High storage costs Risk of obsolescence

Low Levels
Cost: Shortages Dissatisfied customers Benefit: Low storage costs Less risk of obsolescence

Cash
High Levels
Benefit: Reduces risk Cost: Increases financing costs

Low Levels
Benefit: Reduces financing costs Cost: Increases risk
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Befits and cost of high and low levels of working capital

Accounts Receivable
High Levels Benefit: Happy customers supplied quickly High sales - no backorders or stockouts Cost: Expensive High collection costs Increases financing costs Low Levels Cost: Dissatisfied customers Lower Sales Benefit: Less expensive

Payables and Accruals

High Levels Benefit: Reduces need for external finance--using a spontaneous financing source Cost: Unhappy suppliers Low Levels Benefit: Happy suppliers/employees Cost: Not using a spontaneous financing source
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Characteristics of Working Capital

Short life span Swift transformation into other asset forms Current Assets Cycle
Finished goods

Accounts receivable Wages, salaries, factory overheads

Work-inprocess

Raw materials

Cash

Suppliers

Operating Cycle
Operating cycle refers to the time elapsed between procurement of raw material to realization of cash from the finished goods. Larger the operating cycle, larger is the requirement of working capital.

Cash Cycle
Cash cycle refers to the time elapsed between payment of raw material to realization of cash from the finished goods.

Operating Cycle and Cash Cycle

Note that
Operating cycle generally is larger than the cash cycle. Cash cycle = Operating cycle Credit period availed on raw material. Cash cycle would be larger if firms make advance payment for procuring raw material.

Estimating Working Capital

Estimation of working capital can be stated as a four step process: Step 1: Determining the duration (or conversion period) of blockage of funds. Step 2: Estimation of weights of the different components of operating cycle Step 3: Determination of weighted operating cycle (WOC). Step 4: Computation of working capital requirements

Step 1: Determining the duration

Step 2: Estimation of weights of the different components of operating cycle

Step 3: Determination of weighted operating cycle (WOC).

Step 4: Computation of working capital requirements

Factors Influencing Working Capital Requirements

Nature of Business Seasonality of Operations

Production Policy
Market Conditions Conditions of Supply

Nature of Business
The requirements of working is very limited in public utility undertakings such as electricity, water supply and railways
because they offer cash sale only and supply services not products, and no funds are tied up in inventories and receivables.

On the other hand the trading and financial firms requires less investment in fixed assets but have to invest large amt. of working capital along with fixed investments.

Size of The Business

Greater the size of the business, greater is the requirement of working capital.

Production Policy
If the policy is to keep production steady by accumulating inventories it will require higher working capital.

Length of Production Cycle

The longer the manufacturing time, the raw material and other supplies have to be carried for a longer in the process.

Seasonal Variations
Generally, during the busy season, a firm requires larger working capital than in slack season.

Working Capital Cycle

The speed with which the working cycle completes one cycle determines the requirements of working capital. Longer the cycle larger is the requirement of working capital.

Rate of Stock Turnover

There is an inverse co-relationship between the question of working capital and the velocity or speed with which the sales are affected. A firm having a high rate of stock turnover will need lower amt. of working capital as compared to a firm having a low rate of turnover.

Business Cycle

In period of boom, when the business is prosperous, there is need for larger amt. of working capital due to rise in sales, rise in prices, optimistic expansion of business, etc. On the contrary in time of depression, the business contracts, sales decline, difficulties are faced in collection from debtor and the firm may have a large amt. of working capital.

Rate of Growth of Business

In faster growing concern, we shall require large amt. of working capital.

Earning Capacity and Dividend Policy

Some firms have more earning capacity than other due to quality of their products, monopoly conditions, etc. Such firms may generate cash profits from operations and contribute to their working capital. The dividend policy also affects the requirement of working capital. A firm maintaining a steady high rate of cash dividend irrespective of its profits needs working capital than the firm that retains larger part of its profits and does not pay so high rate of cash dividend.

Price Level Changes

Changes in the price level also affect the working capital requirements. Generally rise in prices leads to increase in working capital.

Others factors
Operating efficiency Management ability Irregularities of supply Import policy Asset structure Importance of labor Banking facilities

Working Capital Policy

Two important issues in working capital policy are: What should be the level of investment in current assets? What mix of long-term and short-term financing should the firm employ to support current assets?

Working Capital Policy

Flexible Conservative Policy
A flexible policy results in fewer production stoppages, ensures quicker deliveries to customers, and stimulates sales .. but HIGHER INVESTMENT IN CURRENT ASSETS

Restrictive Aggressive Policy

A restrictive policy leads to more production stoppages, delayed deliveries to customers, and lost sales but LOWER INVESTMENT IN CURRENT ASSETS

Matching Approach
Short-term assets (current assets) should be financed with short-term liabilities (current liabilities) and that long-term assets (fixed assets) should be financed with long-term sources of financing (long-term debt, preferred stock, and common equity). BALANCED INVESTMENT IN CURRENT ASSETS

Figure : Conservative Policy

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Figure : Aggressive Policy

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Methods Of Estimating Working Capital

Two methods usually followed in determining working capital requirements: 1. Conventional Method: According to the conventional method, cash inflows and outflows are matched with each other. 2. Operating Cycle Method Operating cycle of an enterprise is the length of time which is required to convert cash into resources, resources into final product, the final product into receivables and receivables back into cash.

Operating cycle
Inventory raw materials Work-in-progress Semi-finished goods Credit granted to Customers No. of Days 85 40 16 30 171 25 146

Less: Credit allowed by suppliers

This means that, during the year, there will be 365 / 146 = 2.5 Operating Cycles If the operating expenditure during the year is Rs.5,OO,OOO each operating cycle will cost the business 5,00,000 /2.5 = Rs. 2,00,000

Adequacy Of Working Capital

Adverse effects of shrinkage Cash discounts Credit standing Carrying of inventories Credit terms No delay in obtaining materials Business runs smoothly.

Dangers of Excessive Working Capital

Ralph Kennedy and McMullen have observed that the availability of excess working capital may lead to carelessness about costs, and therefore, to inefficiency of operations.

Trade offs Optimal Amount of Current Assets

Profitability varies inversely with liquidity.

note
In 1987-88, the Reserve Bank of India conducted a study on the finance of 417 public limited companies. The overall pattern of distribution of working capital was: Inventories - 42.13 per cent; Loans, advances, investments and book debts - 52.27 per cent; Cash and Bank balances - 5.6 per cent.

WCM in Action
How to get out of Accounts Receivables?
Calling Customers Communication Corporate Culture : Incentive system (Value Oriented, Cash oriented) Quality of Product Benchmarking ? Intimate knowledge of value chain Future Cash flows Leverage of Bargaining Power with suppliers Equilibrium Negotiating Power

Summary
Working capital is a financial metric which represents operating efficiency in a business, organization or other entity.

Test your understanding

The excess of current assets over the current liabilities can be expressed as . The need for working capital varies with changes in the volume of business. ( True or False) The two methods of estimating working capital requirements are ...

Case Dell Computer

WCM in Power Sector

Working capital gives an idea of the company's underlying operational efficiency
Power industry is one of the basic the infrastructural industry of a nation. It has greater utility and is one of the capital intensive industries. Due to their capitalintensive nature, electric utilities are a major presence in the financial markets, particularly in terms of short-term borrowing. Maintaining and improving credit standing and financial health is always important to electric utilities. Among the many challenges facing power utility companies today have to maintain sufficient levels of cash for paying creditors, without negatively affecting the supply chain. Power utilities have to carefully monitor the changing dynamics within their own business environment. Maintaining a particularly sharp focus on internal costs, including the operations and maintenance (O&M) budget, is a prudent course of action to follow.

Many power utilities entities maintain negative working capital balances

 A study shows that many companies in power sector in India have inadequate current ratio (current assets divided by current liabilities). Some other companies showed moderately positive results. The study showed that 94 percent of the companies recorded a positive correlation between sales, output and working capital. It is, thus, inferred that the concerns needs more and more working capital when there is more production and more sales and vice versa.

 Regulators can play an important role Internal Control can play an important role