FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENTWORKING CAPITAL MANAGEMENT

1OVERVIEW OF WORKING CAPTITAL MANAGEMENTWorking capitalSignificance of working capital managementWorking Capital ConceptsKinds of working capitalWorking Capital IssuesFinancing Current Assets: Short-Term and Long-Term MixCombining Liability Structure and Current Asset Decisions

2WORKING CAPITALworking 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.

3SINGNIFICANCE OF WORKING CAPITAL MANAGEMENTIn a typical manufacturing firm, current assets exceed one-half of total assets.Excessive levels can result in a substandard Return on Investment (ROI).Current liabilities are the principal source of external financing for small firms.Requires continuous, day-to-day managerial supervision.Working capital management affects the companys risk, return, and share price.4WORKING CAPITAL CONCEPTS Net Working Capital:net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsider, which are expected to mature for payment within an accounting year & include creditors, bills payable & the outstanding expenses. In other words you can say that this is the excess of current assets over current liabilities. Current Assets Current LiabilitiesGross Working Capital:It refers to the firms investment in current assets. Current assets are the assets, which can be converted into cash within an accounting year or within an operating cyclecash, short-term securities, debtors (accounts receivable & book debts), bills receivable and stock. Working capital turnover:

Working capital turnover= sales/working capitalWorking Capital Management: The administration of the firms current assets and the financing needed to support current assets.5CURRENT ASSETSInventories: Inventories represent raw materials and components, work-in-progress and finished goods.

Trade Debtors: Trade Debtors comprise credit sales to customers.

Prepaid Expenses: These are those expenses, which have been paid for goods and services whose benefits have yet to be received.

Loan and Advances: They represent loans and advances given by the firm to other firms for a short period of time.

Investment: These assets comprise short-term surplus funds invested in government securities, shares and short-terms bonds.

Cash and Bank Balance: These assets represent cash in hand and at bank, which are used for meeting operational requirements. One thing you can see here is that this current asset is purely liquid but non-productive.

6CURRENT LIABILITYSundry Creditors: These liabilities stem out of purchase of raw materials on credit terms usually for a period of one to two months.

Bank Overdrafts: These include withdrawals in excess of credit balance standing in the firms current accounts with banks

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

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

7WORKING CAPITAL FORMATCURRENT ASSETSCURRENT LIABILITIESCash Accounts receivableNotes receivableMarketable securitiesInventoryPrepaid expenses

Total current assetsAccounts payableNotes payableAccrued expensesTaxes payable

Total current liabilities

8POINTS KEPT IN MIND WHILE PLANNING1. Excessive investment (Profitability)

It results in unnecessary accumulation of inventories. Thus, chances of inventory mishandling, waste, theft & losses increase.

b. It is an indication of defective credit policy & slack collection period.

c. Excessive WC makes management complacent, which degenerates into managerial inefficiency.

d. Tendencies of accumulating inventories tend to make speculative profits grow.

9CONT2. Inadequate investment (Liquidity)

It stagnates growth.

It become difficult to implement operating plans and achieve the firms operating profit target.

Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments.

Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the firms profitability would deteriorate.

Paucity of WC funds render the firm unable to avail attractive credit opportunities.

The firm loses its reputation when it is not in a position to honour its short-term obligations.

10KINDS OF WORKING CAPITAL1.Permanent working capital:Permanent working capital is the minimum amount of current assets, which is needed to conduct a business even during the dullest season of the year. The minimum level of current assets is called permanent or fixed working capital as this part is permanently blocked in current assets. 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 business process.

Its size increase with the growth of business operations.

11PERMANENT WORKING CAPITAL

12CONT2.Temporary working capital:Temporary working capital represents a certain amount of fluctuations in the total current assets during a short period. Variable working capital is the amount of additional current asset that are required to meet the seasonal needs of a firm, so is also called as the seasonal working capital. 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.

13TEMPORARY WORKING CAPITAL

14DETERMINANTS OF WORKING CAPITALNature of businessTerms of sales and purchasesManufacturing cycleRapidity of turnoverBusiness cycleChanges in technologySeasonal variationMarket conditionsSeasonality of operationDividend policyWorking capital cycle 15

WORKING CAPITAL ISSUES

Assumptions50,000 maximum units of productionContinuous productionThree different policies current asset levels are possible

16IMPACT ON LIQUIDITYLiquidity AnalysisPolicy Liquidity A HighB Average C Low Greater current asset levels generate more liquidity; all other factors held constant.

17IMPACT ON EXPECTED PROFITABILITYReturn on Investment =Net profit/Total AssetsLet,Current Assets=(Cash+Rec.+Inv.)

Return on Investment=(Net Profit/Current +Fixed Assets)

18IMPACT ON EXPECTED PROFITABILITYProfitability AnalysisPolicy ProfitabilityA LowB Average C High As current asset levels decline, total assets will decline and the ROI will rise.

19IMPACT 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 stock outs and lost sales.

20IMPACT ON RISKRisk AnalysisPolicy RiskA LowB Average C High Risk increases as the level of current assets are reduced.

21SUMMARY OF THE OPTIMAL AMOUNT OF CURRENT ASSETSSUMMARY OF OPTIMAL CURRENT ASSET ANALYSISPolicy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High

Profitability varies inversely with liquidity.Profitability moves together with risk. (risk and return go hand in hand!)22FINANCING CURRENT ASSETS:SHORT-TERM AND LONG-TERM MIXSpontaneous Financing:Trade credit, and other payables and accruals, that arise spontaneously in the firms day-to-day operations.Based on policies regarding payment for purchases, labor, taxes, and other expenses.We are concerned with managing non-spontaneous financing of assets.23HEDGING(or MATURITY MATCHING) APPROACHA method of financing where each asset would be offset with a financing instrument of the same approximate maturity..

24HEDGING(or MATURITY MATCHING) APPROACHLess amount financed spontaneously by payables and accruals.In addition to spontaneous financing (payables and accruals).

25FINANCING NEEDS AND THE HEDGING APPROACHFixed assets and the non-seasonal portion of current assets are financed with long-term debt and equity(long-term profitability of assets to cover the long-term financing costs of the firm).

Seasonal needs are financed with short-term loans (under normal operations sufficient cash flow is expected to cover the short-term financing cost).26SELF-LIQUIDATING NATURE OF SHORT-TERM LOANSSeasonal orders require the purchase of inventory beyond current levels.Increased inventory is used to meet the increased demand for the final product.Sales become receivables.Receivables are collected and become cash.The resulting cash funds can be used to pay off the seasonal short-term loan and cover associated long-term financing costs.27RISKS VS. COSTS TRADE-OFF (CONSERVATIVE APPROACH)Long-term Financing Benefits:Less worry in refinancing short-term obligationsLess uncertainty regarding future interest costsShort-term Financing Risks:Borrowing more than what is necessaryBorrowing at a higher overall cost(usually)Result:Manager accepts less expected profits in exchange for taking less risk.28RISKS VS. COSTS TRADE-OFF (CONSERVATIVE APPROACH)Firm can reduce risks associated with short-term borrowing by using a larger proportion of long-term financing.

29COMPARISON WITH AN AGGRESSIVE APPROACHShort-Term Financing Benefits:Financing long-term needs with a lower interest cost than short-term debtBorrowing only what is necessaryShort-Term Financing Risks:Refinancing short-term obligations in the futureUncertain future interest costsResult:Manager accepts greater expected profits in exchange for taking greater risk.

30RISKS VS. COSTS TRADE-OFF (AGGRESSIVE APPROACH)Firm increases risks associated with short-term borrowing by using a larger proportion of short-term financing.

31SUMMARY OF SHORT- VS. LONG-TERM FINANCING

32COMBINING LIABILITY STRUCTURE AND CURRENT ASSET DECISIONSThe level of current assets and the method of financing those assets are interdependent.A conservative policy of high levels of current assets allows a more aggressive method of financing current assets.A conservative method of financing (all-equity) allows an aggressive policy of low levels of current assets.

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