Chapter 03 working capital 1ce lecture
-
Upload
cma-khursheed-ahmad-bhat -
Category
Documents
-
view
78 -
download
0
Transcript of Chapter 03 working capital 1ce lecture
33Chapt
er
Chapt
er The Management of
Working Capital
Khursheed Ahmad BhatHODDepartment of Hospital Administration
2Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU
Chapter 3 – Outline (1)
• Working Capital Basics Working Capital and the Current Accounts Working Capital and Funding Requirements Objective of Working Capital Management Working Capital Trade-offs Operations—The Cash Conversion Cycle The Operating Cycle and the Cash Conversion Cycle
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU3
Chapter 3 – Outline (2)
Permanent and Temporary Working Capital Maturity Matching Principle Financing Net working Capital Short-Term vs. Long-Term Financing Working Capital Policy
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU4
• Working capital typically means the firm’s holding of current or short-
term assets such as cash, receivables, inventory and marketable
securities.
• These items are also referred to as circulating capital
• Corporate executives devote a considerable amount of attention to the
management of working capital.
Working capital Introduction
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU5
Working Capital Basics
• Working Capital Assets/liabilities required to operate business on day-to-
day basis• Cash• Accounts Receivable• Inventory• Accounts Payable• Accruals
Short-term in nature—turn over regularly
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU6
Concepts of Working Capital
• There are two possible interpretations of working capital concept:
1. Balance sheet concept2. Operating cycle conceptBalance sheet concept
There are two interpretations of working capital under the balance sheet concept. a. Excess of current assets over current liabilities.(CA-CL)
b. Gross or total current assets.(Fixed Assets + Current Assets)
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU7
Working Capital and the Current Accounts
• Gross working capital = Current assets Gross Working Capital (GWC) represents investment in
current assets
• (Net) working capital = Current assets – Current liabilities
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU8
Working Capital and Funding Requirements
• Spontaneous Financing Firm will also always have minimum level of Accounts
Payable—in effect, money you have borrowed• Accounts Payable (and Accruals) are generated spontaneously
• Arise automatically with inventory and expenses • Offset the funding required to support current assets
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU9
Working Capital and Funding Requirements
• Working Capital Requires Funds Maintaining working capital balance requires permanent
commitment of funds• Example: Firm will always have minimum level of Inventory,
Accounts Receivable, and Cash—this requires funding
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU10
Working Capital and Funding Requirements
• Net working capital is Gross Working Capital – Current Liabilities (including spontaneous financing)
Reflects net amount of funds needed to support routine operations
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU11
Concepts Continues 2• Excess of current assets over current liabilities are called the net
working capital or net current assets.
• Working capital is really what a part of long term finance is locked in and used for supporting current activities.
• The balance sheet definition of working capital is meaningful only as an indication of the firm’s current solvency in repaying its creditors.
• When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources.
• In fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU12
• Operating cycle concept• A company’s operating cycle typically consists of three primary
activities: Purchasing resources, Producing the product and Distributing (selling) the product.
These activities create funds flows that are both unsynchronized and uncertain.Unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (for example collection of receivables).
They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy.
Concepts Continues 3
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU13
“ circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivable to cash”
Genestenbreg
Concepts Continues 4
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU14
Objective of Working Capital Management
• To run firm efficiently with as little money as possible tied up in Working Capital Involves trade-offs between easier operation and cost of
carrying short-term assets• Benefit of low working capital
• Money otherwise tied up in current assets can be invested in activities that generate higher payoff
• Reduces need for costly financing
• Cost of low working capital• Risk of shortages in cash, inventory
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU15
Figure 3.1: Types Of Working Capital
• WORKING CAPITAL
• BASIS OF CONCEPT
• BASIS OF TIME
• Gross Workin
g Capital
• Net Working Capital
• Permanent /
Fixed WC
• Temporary /
Variable WC
• Regular WC
• Reserve WC
• Seasonal WC
• Special WC
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU16
Figure 3.2: Operating cycle of a typical company
• Payable • Deferral period
• Inventory conversion• period
• Cash conversion• cycle
• Operating • cycle
• Pay for• Resources• purchases
• Purchase• resources
• Sell• Product• On credit
• Receivable • Conversion period
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU17
Working Capital Trade-offs
InventoryHigh Levels Low Levels
Benefit: • Happy customers• Few production delays (always have needed
parts on hand)Cost: • Expensive• High storage costs• Risk of obsolescence
Cost: • Shortages• Dissatisfied customersBenefit: • Low storage costs• Less risk of obsolescence
CashHigh Levels Low Levels
Benefit:• Reduces riskCost:• Increases financing costs
Benefit:• Reduces financing costsCost:• Increases risk
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU18
Working Capital Trade-offs
Accounts ReceivableHigh Levels (favourable credit terms) Low Levels (unfavourable
terms)
Benefit: • Happy customers• High salesCost: • Expensive• High collection costs• Increases financing costs
Cost: • Dissatisfied customers• Lower SalesBenefit: • Less expensive
Accounts Payable and AccrualsHigh Levels Low Levels
Benefit:• Reduces need for external finance--using a
spontaneous financing sourceCost:• Unhappy suppliers
Benefit:• Happy suppliers/employeesCost:• Not using a spontaneous
financing source
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU19
Current Assets High Level Low Level
Profitability Lower HigherRisk Lower Higher
Working Capital Trade-offs
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU20
Operations—The Cash Conversion Cycle
• Firm begins with cash which then “becomes” inventory and labour Which then becomes product for sale Eventually this will turn into cash again
• Firm’s operating cycle is time from acquisition of inventory until cash is collected from product sales
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU21
Figure 3.3: The Cash Conversion Cycle
Product is converted into cash,
which is transformed into
more product, creating the cash conversion cycle.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU22
Figure 3.4: Time Line Representation of the Cash Conversion Cycle
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU23
The Operating Cycle and the Cash Conversion Cycle
Inventory conversion periodplus: Receivable collection periodequals: Operating cycleminus: Payables deferral periodequals: Cash conversion cycle
• Shortening cash conversion cycle frees up cash to reinvest in business or to reduce debt and interest
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU24
Cash Conversion Cycle Analysis
• Inventory conversion period = Avg. inventory
Cost of sales/365
• Receivable conversion period =Accounts receivable Annual credit sales/365
• Payables deferral period =Accounts payable + Salaries, etc
(Cost of sales + selling, general and admn. Expenses)/365
• Cash conversion cycle = operating cycle – payables deferral period.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU25
Cash Conversion Cycle
PurchaseInventory
Pay forInventory
Sell Inventoryon Credit
CollectReceivables
Operating CycleInventory Conversion PeriodReceivables Collection PeriodPayables Deferral PeriodCash Conversion Cycle
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU26
Importance of working capital
• Importance of working capital Risk and uncertainty involved in managing the cash flows Uncertainty in demand and supply of goods, escalation in cost both
operating and financing costs.• Strategies to overcome the problem
Manage working capital investment or financing such as
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU27
Importance of working capital
Holding additional cash balances beyond expected needs Holding a reserve of short term marketable securities Arrange for availability of additional short-term borrowing
capacity One of the ways to address the problem of fixed set-up cost may
be to hold inventory. One or combination of the above strategies will target the problem
• Working capital cycle is the life-blood of the firm
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU28
Figure 3.5:
Resource flows for a manufacturing firm
• Fixed • Assets
• Production• Process
• Generates
• Inventory
• Accounts • receivable
• Used in
• Accrued Direct
• Labour and
• materials
• Accrued Fixed• Operating• expenses
• Cash and• Marketable • Securities
• Suppliers• Of Capital
• External Financing • Return on Capital
• Collection • process
• Used to• purchase
• Used to• purchase
• Used in
• Working• Capital• cycle
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU29
Figure 3.6: Working Capital Needs of Different Firms
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU30
Three alternative working capital investment policies
• Sales ($)
•C
urr
en
t A
ssets
($
)• Policy C
• Policy A
• Policy B
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU31
Three alternative working capital investment policies-2• Policy C represents conservative approach• Policy A represents aggressive approach • Policy B represents a moderate approach
• Optimal level of working capital investment
• Risk of long-term versus short-term debt
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU32
Permanent and Temporary Working Capital
• Working capital is permanent to the extent that it supports constant or minimum level of sales
• Temporary working capital supports seasonal peaks in business
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU33
• Amount Variable Working Capital• of • Working• Capital
• Permanent Working Capital
Time•
Difference between permanent & temporary working capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU34
Difference between permanent & temporary working capital-2
Variable Working Capital• • Amount • of • Working• Capital • Permanent
Working Capital
• • Time•
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU35
Financing needs over time
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU36
Matching approach to asset financing
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
• Short-term• Debt
• Long-term• Debt +• Equity• Capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU37
Conservative approach to asset financing
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
• Short-term• Debt
• Long-term• Debt +• Equity• capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU38
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
• Short-term• Debt
• Long-term• Debt +• Equity• capital
Aggressive approach to asset financing
FACTORS DETERMINING WORKING CAPITAL
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU39
1. Nature of the Industry2. Demand of Industry3. Cash requirements4. Nature of the Business5. Manufacturing time6. Volume of Sales7. Terms of Purchase and Sales8. Inventory Turnover9. Business Turnover10. Business Cycle11. Current Assets requirements12. Production Cycle
• 13. Credit control14. Inflation or Price level changes15. Profit planning and control16. Repayment ability17. Cash reserves18. Operation efficiency19. Change in Technology20. Firm’s finance and dividend policy
21. Attitude towards Risk
EXCESS OR INADEQUATE WORKING CAPITAL
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU40
Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital.
Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.
Disadvantages of Redundant or Excess Working Capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU41
Idle funds, non-profitable for business, poor ROIUnnecessary purchasing & accumulation of inventories
over required level Excessive debtors and defective credit policy, higher
incidence of B/D.Overall inefficiency in the organization.When there is excessive working capital, Credit
worthiness suffersDue to low rate of return on investments, the market
value of shares may fall
Disadvantages of Inadequate Working Capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU42
Can’t pay off its short-term liabilities in time. Economies of scale are not possible. Difficult for the firm to exploit favourable market situations Day-to-day liquidity worsens Improper utilization the fixed assets and ROA/ROI falls sharply
Management Of Working Capital ( WCM )
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU43
Management of working capital is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter-relationship that exists between them. In other words, it refers to all aspects of administration of CA and CL.
Working Capital Management Policies of a firm have a great effect on its profitability, liquidity and structural health of the organization.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU44
3D Nature of Working Capital Management
• Dimension I• Profitability,
• Risk, & Liquidity
• Dimension I• Profitability,
• Risk, & Liquidity
• Dimension II
• Composition & Level
• of CA
• Dimension II
• Composition & Level
• of CA
• Dimension III
• Composition & Level • of CL
• Dimension III
• Composition & Level • of CL
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU45
Principles Of Working Capital Management
• PRINCIPLES OF WORKING CAPITAL
MANAGEMENT
• Principle of Risk
Variation
• Principle of Cost
of Capital
• Principle of Equity Position
• Principle of Maturity of
Payment
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU46
Maturity Matching Principle
• Maturity (due date) of financing should roughly match duration (life) of asset being financed Then financing /asset combination becomes self-
liquidating• Cash inflows from asset can be used to pay off loan
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU47
Financing Net Working Capital
• According to maturity matching principle Temporary (seasonal) should be financed with short-
term borrowing Permanent working capital should be financed with
long-term sources, such as long-term debt and/or equity
• In practice, firms may use more or less short-term funds to finance working capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU48
Figure 3.7(a):
Working Capital Financing Policies
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU49
Figure 3.7(b):
Working Capital Financing Policies
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU50
Short-Term vs. Long-Term Financing
• The mix of short- or long-term working capital financing is a matter of policy
Use of long-term funds is a conservative policy Use of short-term funds is an aggressive policy
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU51
Short-Term vs. Long-Term Financing
• Short-term financing Cheap but risky
• Cheap—short-term rates generally lower than long-term rates
• Risky—because you are continually entering marketplace to borrow
• Borrower will face changing conditions (ex; higher interest rates and tight money)
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU52
Short-Term vs. Long-Term Financing
• Long-term financing Safe but expensive
• Safe—you can secure the required capital
• Expensive—long-term rates generally higher than short-term rates
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU53
Working Capital Policy
• Firm must set policy on following issues: How much working capital is used Extent to which working capital is supported by short-
vs. long-term financing How each component of working capital is managed The nature/source of any short-term financing used