Working Capital Management

Definition of Working CapitalWorking 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 CAPITALBASIS OF CONCEPTBASIS OF TIMEGross Working CapitalNet Working CapitalPermanent / Fixed WCTemporary / Variable WCRegular WCReserve WCSpecial WCSeasonal 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 CapitalMaintaining 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 31-3-2000LiabilitiesRsAssetsRsEquity Shares200000Goodwill200008% Debentures100000Land and Building150000Reserve & Surplus50000Plant and Machinery100000Sundry Creditors150000InventoriesBills Payable30000Finished Goods 60000Outstanding Expenses20000Work in process40000Bank Overdraft50000Prepaid Expenses20000Provision for Taxation20000Marketable Securities60000Proposed Dividend30000Sundry Debtors90000Bills Receivables20000Cash & Bank Balance90000TOTAL650000TOTAL650000

Difference between permanent & temporary working capital

Amount Variable Working Capitalof WorkingCapital

Permanent Working Capital

Time Permanent and temporary working capital for Stable firm

Variable Working CapitalAmount of WorkingCapital 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 operationsSuccessful sales activity is necessary for earning profit sales do not convert into cash immediatelyThere 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 progressConversion of Work in progress into finished goods Conversion of finished good into Sales ( Debtors and cash )

Operating Cycle in Manufacturing firm CashRawMaterialsW I PFinished GoodsDebtorsSALES

Operating cycle of Non Manufacturing Firm cashReceivablesStock of finished goods

Formula for calculating Operating cycle for Manufacturing firm OC = ICP+ARPOC = Operating cycle ICP = Inventory Conversion period ARP = Account Receivable Period

ICP = Average Inventory Cost of good sold /365ARP = 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 LakhsCost of Goods Sold Rs 2675 Lakhs

CASH CONVERSION CYCLEThe 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 APPAAI = Average Inventory Cost of good sold /365ARP = 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- APPOC = AAI+ARP 80+50=130CCC =130-40 =90 days

Purchase of Sale of Goods Collection of Raw Material on Credit Account Receivables On credit

Average age of Account receivable Inventory (AII) period (ARP)

Account Payable Period (APP)

Payment to suppliers

Receipt of InvoiceOperating Cycle (OC)Cash Conversion cycle

Resource flows for a manufacturing firm Fixed AssetsProductionProcessGeneratesInventoryVia Sales GeneratorAccounts receivableUsed inAccrued DirectLabour and materialsAccrued FixedOperatingexpensesCash andMarketable SecuritiesSuppliersOf CapitalExternal Financing Return on Capital Collection processUsed topurchaseUsed topurchaseUsed inWorkingCapitalcycle

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

FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTS

Factors to be consideredTotal costs incurred on materials, wages and overheadsThe 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 ) xxxAdd : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

1. MANUFACTURING CONCERN

STATEMENT OF WORKING CAPITAL REQUIREMENTSAmount (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 )xxxxAdd : Provision / Margin for Contingencies-----

NET WORKING CAPITAL REQUIREDXXX

Prepare an estimate of Working capital requirement from the following information of a trading concern:

Projected annual sales 100000 unitsSelling priceRs 8 per unit % age of Net profit on sales25%Average Credit Period allowed to customer8 weeks Average Credit Period allowed by supplier4 weeksAverage stock holding in terma of sales requirement 12 weekscontingencies10%

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 1500008% Debentures 200000Fixed asset 130000Material40%Direct lab our 20%Overheads 20%

The following further particular are available It is proposed to maintain a level of activity of 2,00,000 unitsSelling price is Rs 12/- per unitRaw Material are expected to remain in stores for an average period of one monthMaterial 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 monthCredit allow by supplier is one month

Working Capital Financing MixApproaches to Financing MixThe Hedging or Matching Approach The Conservative ApproachThe Aggressive Approach

Hedging approach to asset financing Fixed AssetsPermanent Current AssetsTotal AssetsFluctuating Current AssetsTimeShort-termDebt Long-termDebt +EquityCapital

The Hedging approach 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.

Estimated Total Investment in Current Asset of company X for the year 2000MonthInvestment in Current Asset (R's )Permanent or Fixed Investments (R's)Temporary or seasonal Invest (R's)January50400450005400February50000450005000March48700450003700April48000450003000May46000450001000June4500045000-July47500450002500August48000450003000September49500450004500October50700450005700November52000450007000December48500450003500TOTAL44300

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 greaterRisk is minimizedThe 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 Fixed AssetsPermanent Current AssetsTotal AssetsFluctuating Current AssetsTimeShort-termDebt Long-termDebt +Equity capital

Trade off between Hedging and conservative approachesThe 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 managementA 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 Fixed AssetsPermanent Current AssetsTotal AssetsFluctuating Current AssetsTimeShort-termDebt Long-termDebt +Equity capital

Aggressive approachThe 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 sourcesThis approach make the finance mix :More RiskyLess costly More Profitable

Prepare a projected balance sheet , profit and loss a/c and then an estimation of working capital .Issued Share Capital 3000006% Debentures 200000Fixed asset 200000Raw Material50%Lab our 20%Overheads 20%Profit10%There is a regular production and sales cycle

Raw Material are kept in stores for an average period of two monthFinished 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 alsoEach unit of production is expected to be in process for half a monthCredit allow to customer is three month and given by supplier is two monthSelling 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 IProfitability, Risk, & LiquidityDimension IIComposition & Level of CADimension IIIComposition & Level of CL

Working Capital IssuesAssumptions50,000 maximum units of productionContinuous productionThree different policies for current asset levels are possibleOptimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSET LEVEL Current AssetsPolicy CPolicy APolicy B

Impact on LiquidityLiquidity AnalysisPolicyLiquidity AHigh BAverage CLowGreater current asset levels generate more liquidity; all other factors held constant.Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSET LEVEL Current AssetsPolicy CPolicy APolicy B

Impact on Expected ProfitabilityReturn on Investment =Net ProfitTotal AssetsLet Current Assets = (Cash + Rec. + Inv.)Return on Investment = Net ProfitCurrent + Fixed AssetsOptimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSET LEVEL Current AssetsPolicy CPolicy APolicy B

Impact on Expected ProfitabilityProfitability AnalysisPolicy Profitability ALow BAverage CHighAs current asset levels decline, total assets will decline and the ROI will rise.Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSET LEVEL Current AssetsPolicy CPolicy APolicy B

Impact on RiskDecreasing 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!Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSET LEVEL Current AssetsPolicy CPolicy APolicy B

Impact on RiskRisk AnalysisPolicyRisk ALow BAverage CHighRisk increases as the level of current assets are reduced.Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSET LEVEL Current AssetsPolicy CPolicy APolicy B

Summary of the Optimal Amount of Current AssetsSUMMARY OF OPTIMAL CURRENT ASSET ANALYSISPolicyLiquidity Profitability Risk A High Low Low BAverage Average Average C Low High High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk.(risk and return go hand in hand!)

Techniques of analysis of working capital The analysis of working capital can be conducted through a number of devices such as Ratio analysisFund 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.

The following ratios may be calculated for this purpose Liquidity RatioCurrent RatioAcid test ratio/quick ratio/liquid ratio Cash Position ratio/absolute liquid ratio Inventory turnover ratioReceivable turnover ratioPayable turnover ratioWorking 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 CURRENT LIABILITIESCash in hand Bills Payable Cash at bank Sundry CreditorsSundry DebtorsAccrued or Outstanding ExpensesMarketable securities (Short term)Short term loan and advancesBills Receivable Dividend payable Inventories of Stock Bank OverdraftWork in progressFinished goods Prepaid Expenses

Quick or Acid test or Liquid RatioAn 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 immediatelyThe quick ratio can be calculated Quick ratio: liquid asset Current liabilities

Convection quick ratio of 1:1 is consider satisfactory

Quick or liquidCurrent LiabilitiesCash in hand Bills Payable Cash at bank Sundry CreditorsSundry DebtorsAccrued or Outstanding ExpensesMarketable securities Short term advancesTemporary Investments Dividend payable Bank OverdraftIncome tax payable

Cash Position ratio/absolute liquid ratioAbsolute 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 RsAssets Rs9% preference share 500000Goodwill100000Equity share capital 1000000Land and building 6500008% debentures200000Plant800000Long term loan 100000Furniture and fixtures150000Bills payable 60000Bills receivable 70000Sundry creditors70000Sundry debtors90000Bank over draft 30000Bank balance45000Outstanding expenses 5000short term investments 25000Prepaid expenses 5000Stock3000019650001965000

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 1:1Absolute 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 costInventory 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 SalesRs 250000 Return Inward Rs 25000 Opening Stock Rs 25000 Closing Stock Rs 35000

Debtor/Receivable turnover ratio/Debtor velocity

Debtor(Receivable) = Net credit Annual sales Average Trade debtorsTrade debtors = Sundry debtor + Bill Receivable and account receivable s Average Trade Debtors = Opening Trade debtor + Closing Trade Debtor /2Note : 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

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 daysIf 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 ratioWorking 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. Cost of sale /Net working capital

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

FIND OUTAverage StockPurchasesCredit turnover ratio Average Payment PeriodAverage Collection PeriodWorking 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 businessThe 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 .

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