Chapter 26

WORKING CAPITAL MANAGEMENT

OUTLINE
Introduction Constituents of current assets & current liabilities

Characteristics of Current Assets

Factors Influencing Working Capital Requirements

Level of Current Assets

Current Assets Financing Policy Profit Criterion for Current Assets Operating Cycle Analysis Cash Requirement for Working Capital

INTRODUCTION
This chapter introduces working capital management or short term financial management which is concerned with decisions relating to current assets & current liabilities The key difference between LTFM & WCM is in terms of the timing of cash

Two concepts of working capital: a. Gross working capital: Total of all current assets b. Net working capital: Current assets Current Liabilities Importance of Working Capital: a. Investment in current assets represents a substantial portion of total investment b. Investment in current assets & the level of current liabilities have to be geared quickly to changes in sales

CONSTITUENTS OF CURRENT ASSETS & CURRENT LIABILITIES

Current Assets: Inventories - Raw material - Work in Process - Finished Goods - Others Trade Debtors Loans & Advances Cash & Bank Balance Current Liabilities: Sundry Creditors Trade Advances Borrowings [Short Term] - Commercial Banks - Others Provisions

CHARACTERISTICS OF CURRENT ASSETS

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

Implications of Current Assets:

1. Decisions relating to working capital management are repetitive and frequent 2. The difference between profit and present value is insignificant 3. Efficient management of one component cannot be undertaken without simultaneous consideration of other components

FACTORS INFLUENCING

WORKING CAPITAL REQUIREMENTS

Nature of Business

-Service Firm: Modest WC requirement

-Manufacturing Firm: Substantial WC requirement Seasonality of Operations Production Policy Market Conditions Conditions of Supply

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?

LEVEL OF CURRENT ASSETS

Flexible (Conservative) Policy High Large High Restrictive (Aggressive) Policy Low Small Low

Liquidity Inventories Debtors

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

A restrictive policy leads to more production stoppages, delayed deliveries to customers, and lost sales but
LOWER INVESTMENT IN CURRENT ASSETS - Refer Exhibit 26.4 on Page 695

CAPITAL REQUIREMENTS AND THEIR FINANCING

Fluctuating current asset requirement

Capital requirements
A B C

Permanent current asset-requirement

Fixed asset requirement

Time

- Refer Page 696

CURRENT ASSETS FINANCING

POLICY
According to the matching principle, fixed assets and permanent current assets should be supported by long-

term sources of finance whereas fluctuating current assets

must be supported by short-term sources of finance.

PROFIT CRITERION FOR

WORKING CAPITAL
Investment in current assets is easily reversible. For reversible investments, the criterion of net profit per period (which here means residual income) is equivalent to the criterion of net present value

OPERATING CYCLE AND CASH CYCLE

The investment in working capital is influenced by four key events in the production and sales cycle of the firm: -Purchase of raw materials -Payment of raw materials -Sale of finished goods -Collection of cash for sales

OPERATING CYCLE AND CASH CYCLE

Order placed Stock arrives Inventory period Goods sold Cash received Accounts receivable period

Accounts payable period Firm receives invoice Cash paid for materials Operating cycle Cash cycle Average inventory Inventory period = Average COGS / 365 Average accounts receivable Accounts receivable period = Annual sales / 365 Average accounts payable Average payable period = Average COGS / 365 -The operating cycle= Inventory period + Accounts receivable period -The cash cycle= Operating cycle - Accounts payable period

ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data Profit and Loss Account Data Sales Cost of goods 800 720 Inventory Accounts receivable Beginning of 20X0 96 86 End of 20X0 102 90

Sold

Accounts payable

56

60

(96 + 102) / 2

Inventory period =
720 / 365

= 50.1 days

(86 + 90) / 2

Accounts receivable period =

800 / 365 (56 + 60) / 2

= 40.2 days

Accounts payable period

=
720 / 365

= 29.4 days

Operating cycle

50.1 + 40.2 = 90.3 days Inventory Accounts period receivable period

Cash cycle

90.3 29.4 = 60.9 days Operating Accounts cycle payable period

CASH REQUIREMENT FOR

WORKING CAPITAL
Step 1 : Estimate the cash cost of various current assets

required by the firm. Step 2 : Deduct the spontaneous current liabilities from
the cash cost of current assets

- Refer Page 701

SUMMING UP

Current assets have a short life span and are swiftly transformed into other asset forms.
The working capital needs of a firm are influenced by numerous factors : nature of business, seasonality of operations, production policy, market conditions, and supply conditions. Determining the optimal level of current assets involves a tradeoff between carrying costs and shortage costs.

According to the matching principle, the maturity of the sources of finance should match the maturity of assets being financed.

 The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivables. The cash requirement of working capital is calculated by estimating the cash cost of various current assets required by the firm and deducting the spontaneous current liabilities from the cash cost of current assets.

PRACTICE TIME!!!
- Refer to the SOLVED PROBLEMS given at the end of the chapter - Solve all UNSOLVED PROBLEMS