Working capital decisions in Financial management

02/05/2023 BCH 505 PROJECT FINANCE BY DR N R KIDWAI, INTEGRAL UNIVERSITY 1

Working Capital DecisionsWorking Capita l : Meaning and s ignificance, work ing cap ita l cyc le , Work ing cap ita l Management, overa l l cons iderations in WCM; determinants and determination of work ing cap i ta l requirements ; management of cash; management of rece ivables management of Inventor ies .


Working Capital

Working capital or Gross working capital is equal to current assets. Net working capital is current assets minus current liabilities.

in any organization, most of the time finance managers are concerned with working capital management like

# Ensuring that enough cash exists to pay bills; # Ensuring that enough inventory exists to make and sell products; # Ensuring that any excess cash is invested in interest-bearing securities; # Ensuring that accounts receivable are at a level that maximizes earnings, # Ensuring that short-term borrowings such as salaries payable and trade credit are used efficiently and at the lowest cost possible.


Working CapitalCURRENT ASSETS constitute the following: 1. Inventories: raw materials and components, work-

in progress and finished goods. 2. Trade Debtors: credit sales to customers. 3. Prepaid Expenses: expenses, which have been paid

for goods / services in advance4. Loan and Advances: given by the firm to other firms

for a short period of time. 5. Short term Investment: short-term surplus funds

invested in government securities, shares and short-terms bonds.

6. Cash : cash in hand and at bank, which are used for meeting operational requirements.

CURRENT LIABILITIES comprise the following: I. Sundry Creditors: These liabilities stem out of

purchase of raw materials on credit terms usually for a period of one to two months.

II. Bank Overdrafts: These include withdrawals in excess of credit balance standing in the firm’s current accounts with banks

III. Short-term Loans: Short-terms borrowings by the firm from banks and others form part of current liabilities as short-term loans.

IV. Provisions: These include provisions for taxation, proposed dividends and contingencies.


Working CapitalEx. Ace Ltd has the following selected assets and liabilities: Cash : Rs 10,000 Accounts receivable : Rs 30,000 Inventory : Rs 42,000 Machinery : Rs 90,000 long-term investments : Rs 36,000 Patent : Rs 4,000 Accounts payable : Rs 12,000 Taxes payable : Rs 3,000 Accrued expenses payable : Rs 5,000 Bonds payable : Rs 50,000 Common stock : Rs 70,000

The net working capital is: CURRENT ASSETS Cash Rs 10,000 Accounts receivable Rs 30,000 Inventory Rs 42,000 Total Current assets Rs 82,000 CURRENT LIABILITIES Accounts payable Rs 12,000Taxes payable Rs 3,000 Accrued expenses. payable Rs 5,000 Total Current liabilities Rs 20,000 Net working capital Rs 62,000


Working Capital Management working capital management involves the relationship between a firm's short-

term assets and its short-term liabilities. The basic goal of working capital management is to ensure that a firm is able to

continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses.

The management of working capital involves managing inventories, accounts receivable, accounts payable and cash


Types of Working CapitalWORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC


Gross and Net Working CapitalGross working capital refers to current assets

Net working capital refers to difference of current assets and current liabilities.

Net working capital shows the ability to meet current liabilities

Gross working capital or current assets Current liabilities Net working capital - =


Gross working capital

Excessive investment (Profitability) o results in unnecessary accumulation of

inventories. o is indication of defective credit policy &

stock collection period. o Excessive WC leads to managerial

inefficiency. o Tendencies of accumulating inventories

tend to make speculative profits grow.

Inadequate investment (Liquidity) o difficult to achieve operating profit target. o difficult to meet day-to-day commitments. o Inefficient utilization of Fixed assets due to

lack of WC funds. o Paucity of WC funds stops to avail

attractive credit opportunities. o The reputation loss due to dishonour of

short-term obligations

Gross working capital concept focuses optimizing investment in current asset. Two danger points of gross WC approach i.e. excessive and inadequate investment in current assets.

Working Capital Approaches

Sales (Rs)Current Assets (Rs)

Policy C

Policy A

Policy B

Policy A represents aggressive approach Policy B represents a moderate approachPolicy C represents conservative approach


Types of working capital: Permanent Working Capital

Permanent working capital is the minimum amount of current assets required on a continuing basis over the entire year, and for several years., which is needed to conduct a business. This level of current assets is called permanent or fixed working capital as this part is permanently blocked .It is the amount of funds required to produce the goods and services, which are necessary to satisfy demand at a particular point of time.

Characteristics of Permanent working capital • It is classified on the basis of the time period • It constantly changes from one asset to another and continues to remain in the process. • Its size increase with the growth of business operations


Types of working capital: Temporary Working Capital

Temporary working capital represents a certain amount of fluctuations in the total current assets during a short period to meet the seasonal needs of a firm, so is also called as the seasonal working capital. For example: additional inventory will be required for meeting the demand during the period of high sales. It is temporarily invested in current assets. Say for an example a shopkeeper invests more money during winter season because he/ she requires to keep more amount of stock of woollen cloths. Characteristics of Temporary working capital • It is not always gainfully employed, though it may change from one asset to another asset, as permanent working capital does. • It is particularly suited to business of a seasonal or cyclical nature.


Types of working capital:

Variable Working Capital

Permanent Working CapitalAm

ount

of W

orki

ng

Capi

tal

Time


Working Capital: DeterminantsNature of business: The WC requirements of an enterprise are basically related to the nature of the business. Public utility /service sector business need very limited WC as they offer cash sales / services, as no funds are ties up in inventories and receivables. The manufacturing concerns require sizable working capital, as they have to build up inventories.

Terms of sales and purchases: Credit sales granted by the concerns to its customers as well as credit terms granted by the suppliers also affect the working capital. With more favourable credit terms, WC requirements can be reduced.

Manufacturing cycle: The length of manufacturing cycle influences the quantum of WC. Shorter the manufacturing cycle; lesser the WC required. Manufacturing cycle is the time required for raw materials to be converted into finished goods in production process. Manufacturing cycle depends on the nature of product as well as production technology.


Working Capital: DeterminantsRapidity of turnover: If the inventory turnover is high, the WC requirements will be low. With a better inventory control, a firm is able to reduce its WC requirements. When a firm has to carry on a large inventory of slow moving stock, it needs a larger WC as against another whose turnover is rapid.

Business cycle: Cyclical changes in the economy also influence quantum of WC.

Changes in technology: Changes in technology may lead to improvements in processing, savings in wastage, increased productivity, and efficiency thus requires reduced WC .

Seasonal variation: The inventory of raw materials, spares depends on the condition of supply. if the supply is unpredictable and scant then the firm would have to acquire stocks as they are available and carry larger inventory, , to ensure the continuity of production,


Working Capital: DeterminantsMarket conditions: The degree of competition prevailing in the market place has an important bearing on WC needs. When competition is keen, a larger inventory of finished goods is required to promptly serve customers.

Seasonality of operation: Firms, which have marked seasonality in their operations usually, have highly fluctuating WC requirements. For ex. A firm manufactures fans. The sale of fans reaches a peak during the summer months and drops sharply during the winter. The WC need of such a firm is likely to increase considerably in summer and decrease during winters.

Dividend policy: It has a dominant influence on the WC position of a firm. If the firm is following a conservative dividend policy, the need for WC can be met with retained earnings.

Working capital cycle: Larger the WC cycle, more is the requirement of working capital.


The Working Capital Cycle (Operating Cycle)

Accounts Payable

Cash

RawMaterials

W I P

Finished Goods

Value Addition

AccountsReceivable

SALES

Operating cycle of a typical company

Payable Deferral period

Inventory conversionperiod

Cash conversioncycle

Operating cycle

Pay forResourcespurchases

Receive CashPurchase

resources

SellProductOn credit

Receivable Conversion period

Cash conversion cycle = operating cycle – payables deferral period.

Operating cycle of a typical company


Working Capital: Management of Cash Cash refers to currency and demand deposits. Cash management involves having the

optimum, neither excessive nor deficient, amount of cash on hand at the right time. The objective of cash management is to invest excess cash for a return while retaining

sufficient liquidity to satisfy future needs. The amount of cash to be held depends upon the following factors: • Cash management policies • Current liquidity position • Management’s liquidity risk preferences • Schedule of debt maturity • The firm’s ability to borrow • Forecasted short- and long-term cash flow


Working Capital: Management of CashThe company should not have an excessive cash balance since no return is being earned upon it. The least amount of cash a firm should hold is the greater of the two1) compensating balances (a deposit held by a bank to compensate it for providing services)2) precautionary balances (money held for emergency purposes) plus transaction balances

(money needed to cover checks outstanding).

When cash receipts and disbursements are highly synchronized and predictable, a firm may keep a small cash balance. The financial manager must accurately forecast the amount of cash needed, its source, and its destination. These data are needed on both a short- and a long-term basis.


Working Capital: Management of Accounts Receivable

Management of Accounts Receivable is important as there is an opportunity cost associated with holding receivable balances. The major decision is the determination of the amount and terms of credit to extend to customers. The credit terms offered have a direct bearing on the associated costs and revenue to be generated from receivables.

For example, if credit terms are tight, there will be less of an investment in accounts receivable and less bad debt losses, but there will also be lower sales and reduced profits.

In evaluating a customer’s ability to pay, consideration should be given to the firm’s integrity, financial status, collateral to be pledged, and economic conditions. A customer’s credit soundness may be evaluated through quantitative techniques. The collection period for accounts receivable partly depends on the ’ firm’s credit policy and economic conditions, such as a recessionary environment, a period of limited or tight credit, or both.



In managing accounts receivable, the following procedures are recommended. First, establish a credit policy: 1. A detailed review of a potential customer’s soundness should be made prior to extending

credit. Procedures such as a careful review of the customer’s financial statements and credit rating, are common.

2. As customer financial health changes, credit limits should be revised. 3. Marketing factors must be noted as more restricted credit policy will lead to lost sales. 4. If seasonal dating's are used, the firm may offer more liberal payments than usual during

slow periods in order to stimulate business. This policy is financially appropriate when the return on the additional sales plus the lowering in inventory costs is greater than the incremental cost associated with the additional investment in accounts receivable.



Second, establish policy concerning billing: 1. Customer statements should be sent within 1day subsequent to the close of the period. 2. Large sales should be billed immediately. 3. invoice for goods when the order is processed rather than when it is shipped. 4. Billing for services should be done on an interim basis or immediately prior to the actual

services. The billing process will be more uniform if cycle billing is employed. 5. The use of seasonal dating's should be considered. Finally, establish policy concerning collection: 1. Accounts receivable should be aged' in order to identify delinquent and high-risk

customers. The aging should be compared to industry norms. 2. Collection efforts should be undertaken at the very first sign of customer financial

unsoundness


Working Capital: Management of InventoriesThe three types of inventory are: • raw materials, materials acquired from a supplier to be used in manufacture of goods; • work-in-process, which is partially completed goods at the end of the accounting period; • finished goods, which are completed goods awaiting sale. In managing inventory, the financial manager should: • Appraise the adequacy of the raw materials level, which depends on expected

production, condition of equipment, and any seasonal considerations of business. • Forecast future movements in raw materials prices, • Discard slow-moving products to reduce inventory carrying costs and improve cash flow. • Guard against inventory build-up, since it associates carrying and opportunity costs. • Minimize inventory levels when liquidity and/or inventory financing problems exist. • Plan for a stock inventory balance that will guard against material shortage.


Working Capital: Management of Inventories• Examine the quality of merchandise received. A sharp increase in the ratio of purchase

returns to purchases indicates that a new supplier may be needed. • Keep a careful record of back orders. A high back order level indicates that less inventory

balances are required. The trend in the ratio of the amount of back orders to the average per-day sales will prove useful.

• Appraise the acquisition and inventory control functions. In areas where control is weak, inventory balances should be restricted.

• supervise warehouse/materials handling staff to guard against theft and loss of efficiency. • Minimize the lead time in the acquisition, manufacturing, and distribution. The lead time

in receiving goods is the value of outstanding orders divided by average daily purchases. • Examine the degree of spoilage. • Maintain proper inventory control


Working Capital: Management of Inventories• The financial manager must also consider the risk associated with inventory while

computing the desired inventory. For example, perishable, fashionable, goods have a high realization risk.

• Inventory management involve a trade-off between the costs vs benefits of holding inventory.

• Higher inventory levels result in increased costs from storage, insurance, spoilage, and interest on funds. However, it lowers the possibility of lost sales from stock outs and the incidence of production slowdowns. Further, bulk purchases will result in greater purchase discounts.

• Inventory levels are also influenced by short-term interest rates. For example, as short-term interest rates increase, the optimum level of holding inventory will be reduced.

• Inventory should be counted at, cyclic intervals


Inventory Control: Economic Order Quantity [ EOQ ]

The ordering quantity problems are solved by the firm by determining the EOQ ( or the Economic Lot Size ) that is the optimum level of inventory. The EOQ is that level of inventory which MINIMIZES the total of ordering and carrying costs.C = Consumption /Annual Usage / DemandQ = Quantity OrderedO = Ordering Cost per OrderI = Inventory Carrying Cost (as a % on P )P = Price per UnitTotal Cost of Ordering & Carrying Again Cost of ordering & carrying inventory TC is minimized at EOQ


Inventory Control: Different Classification Methods

Classification BasisABC

[Always Better Control ]Value of items consumed

VED[ Vital, Essential, Desirable ]

The importance or criticality

FSN[ Fast-moving, Slow-moving, Non-moving ]

The pace at which the material moves

HML [ High, Medium, Low ]

Unit price of materials

SDE[ Scarce, Difficult, Easy ]

Procurement Difficulties

XYZ Value of items in storage


Ratios associated with WCM

Working capital decisions in Financial management

Economy & Finance

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