10 pointers working capital

7/31/2019 10 Pointers Working Capital

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STUDY -6 FTFM

1. Explain the concept of Working Capital.

Ans: The term working capital refers to the amount of capital which isreadily available to an organization. Working capital finances the CashConversion Cycle of a business-the time required to convert raw

materials into finished goods, finished goods into sales, and accountsreceivable. The term working capital may be used in two different ways:A. Gross Working Capital- It refers to the firms investment in all the

current assets. It is based on following premises:I. With every increase in funds, the gross working capital will

increase.II. The management is more concerned with total current assets

as they constitute the total funds available for operatingpurpose than with the sources from which the funds came

Example:The ABC Limited has a cash balance of Rs.10,000 , Debtors ofRs.50,000 , Inventory of Raw material Rs.1,00,000 and Inventory of

Finished goods Rs.2,00,000 then gross working capital of ABC Limitedwill be Rs.3,60,000.

B. Net Working Capital- It refers the amount of current assets thatexceeds current liabilities. It is the amount of current assets financedby long-term liabilities. It is based on following premises:

I. In the long run what matters is the surplus of currents assetsover current liabilities.

II. The creditors and investor use this concept to judge thefinancial soundness of the enterprise.

III. To meet the contingencies one has to rely upon the excess of

current assets over current liabilities.IV. It helps to find out the correct financial position of companies.

The net working capital measures firms liquidity.

The net working capital may be negative or positive.

Formula

Net working capital= Current Assets- Current liabilities

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Temporary working capital: The amount of temporary workingcapital fluctuates depending upon the changes in the production andsales.

Temporary working capital = fluctuating working capital = variable

working capital

S.no

Permanent WorkingCapital

Temporary WorkingCapital

1 It refers to the minimumamount which is invested inthose current assets which isconstantly and continuouslyrequired by a business unit tocarry on its operations.

It refers to that workingcapital, the requirement ofwhich keeps on fluctuatingdepending on the needs of thebusiness unit. Any amountover and above the

permanent level of workingcapital is variable, temporaryor fluctuating working capital.

2 This type of working capitalshould be financed from longterm sources of finance.

This type of working capital isgenerally financed from shortterm sources of finance suchas bank credit because thisamount is not permanentlyrequired and is usually paidback during off season or afterthe contingency.

3 It grows with the size of thebusiness and it remains in thebusiness in one or the otherform

Its requirement depends uponthe project undertaken by thecompany or firm.

4 The supplier of fund shouldnot expect return during thelife time of business in one orother form.

The supplier of fund canexpect return during the offseasons when the WC is notrequired.

Temporary WC

3

INR

AMOU

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Permanent WC

TIME

INR AMOUNT

Temporary WC

Permanent WC

TIMEThe above figure shows that the Permanent working capital may eitherbe constant over a period of time. Further, that the permanent workingcapital is constant or increasing regularly while temporary workingcapital is fluctuating from time to time. The fund manager has toarrange fund for investment in temporary working capital needs withoutloss of time.

1. What are the different Approaches to financing of working

capital requirements? Explain in detail.Ans: Matching approach or Hedging approach-A method of financing where each asset would be offset with afinancing instrument of the same approximate maturity. The hedgingprinciple states that the financing maturity should follow the cashflow characteristics of the assets being financed. For example anasset that is expected to provide cash flows over a period of say, 6years then it should finance with a debt having similar pattern ofcash flow requirements.When the firm follows matching approach, long term financial will beused to finance permanent working capital. Temporary working

capital should be financed out of short term funds. The rationaleunderlying matching approach is that the maturity of sources of

funds should match the nature of assets to be financed.

Fluctuating WC short Term financing

Amountofworking

capit

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Permanent working capitalLong Term financing

Time

Figure: Matching Long-Term and Short-Term needs

If you refer to the above diagram, the fixed working capital isfinanced with the long-term capital& equity funds, whereasfluctuating current assets are financed with short-term debt. Forexample, a seasonal expansion in inventories should be financed withshort term loan. The rationale of the hedging principal is straightforward. The Financing mix a suggested by the hedging approach is adesirable financing pattern.

Conservative Approach- According to this approach allrequirement of funds should be met from long-term sources. Short-term sources should be used only for emergency situations only.Under a conservative plan, a firm finances its permanent currentassets and a part of the temporary current assets with a long-termfinancing. In periods when the firm has no temporary current assets,it stores liquidity by investing surplus funds in marketable securities.Conservative approach is less risky but more costly as compared tomatching approach. In other words it is low profit low risk approach.

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8-22

(Conservative Approach)(Conservative Approach)

Firm can reduce risks associated with shortFirm can reduce risks associated with short --term borrowingterm borrowing

by using a larger proportion of longby using a larger proportion of long --term financing.term financing.

TIMEAMOUNTOF

WORKINGCAPITAL

Long -term financing

Fixed assetsFixed assets

Current assetsCurrent assets

ShortShort --term financingterm financing

Figure: Using Long-term Financing for part of short-term needs

The shaded area shows that a part of temporary working capital isfinanced by long term sources.

Aggressive Approach- Under an aggressive policy the firm finances apart of its permanent current assets with short-term financing. On theother hand more use of short-term financing makes the firm more risky.This policy seeks to minimize excess liquidity while meeting the shortterm requirements. The firm may accept even greater risk of insolvencyin order to save cost of long term financing and thus in order to earngreater return. Under Aggressive working capital policy, investment incurrent Assets is very low. The firm keeps less amount of cash andmarketable securities, manages with less inventories and tight creditterms resulting in low level of debtors. The consequences of aggressiveworking capital policy are frequent production stoppages, delayeddeliveries to customers and loss of sales.

The aggressive approach to financing working capital has been shown infigure

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Permanent workingcapital

Short term financingAmount ofWorking short term financingcapital Long term sources

Time

Figure: Aggressive Financing Plan

2. Explain the difference between Hedging Approach andConservative Approach.

Ans. Both Hedging Approach and Conservative Approach do not helpmuch finance manager in managing the working capital needs. TheHedging Approach is more risky as short term assets are financed byshort term liabilities only and firm may not have sufficient liquidity withit. On the other hand Conservative Approach is more costly as long term

sources may remain idle in slack period.Hedging Approach Conservative Approach

The cost of financing is reduced It is less risky and firm is able to absorb

shocks.

The investment in net working capital

is minimum

The firm does not face frequent financing

problems

Frequent efforts are require to arrange

funds.

The cost of financing is definitely higher

The risk is increased as the firm is

vulnerable to sudden shocks.

Large investment is blocked in temporary

working capital

The Conservative Approach provides liquidity in excess of expectedneeds and thus minimizes the risk of not being able to financespontaneous asset growth. Neither the Hedging Approach norConservative Approach can be used by any firm in the strict sense.Therefore financial manager should try to have trade-off betweenHedging Approach and Conservative Approach.

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3. Explain the risk and return Trade-off of current asset

Financing.

Ans. The financing of current assets involves a trade off between riskand return. A firm can choose from short or long term sources offinance. Short term financing is less expensive than long term financingbut at the same time, short term financing involves greater risk thanlong term financing.Depending on the mix of short term and long term financing, theapproach followed by a company may be referred as matchingapproach, conservative approach and aggressive approach.In matching approach, long-term finance is used to finance fixed assets

and permanent current assets and short term financing to financetemporary or variable current assets. Under the conservative plan, thefirm finances its permanent assets and also a part of temporary currentassets with long term financing and hence less risk of facing theproblem of shortage of funds.An aggressive policy is said to be followed by the firm when it uses moreshort term financing than warranted by the matching plan and financesa part of its permanent current assets with short term financing.There are two types of risks inherent in working capital management,namely, liquidity risk and opportunity loss risk. Liquidity risk is the nonavailability of cash to pay a liability that falls due. Even though it may

happen only on certain days, it can cause, not only a loss of reputationbut also make the work condition unfavourable for getting the bestterms on transaction with the trade creditors. The other risk involved inworking capital management is the risk of opportunity loss i.e. risk ofhaving two little inventory to maintain production and sales, or the riskof not granting adequate credit for releasing achievable level of sales. Inother words it is a the risk of not been able to produce more or sell moreor both, and therefore, not being able to earn the potential profits,because there are not enough funds to support higher inventory andbook debts. thus, it would not out of place to maintain that is onlytheoretical that the current assets could zero values. Indeed, it is neither

practicable nor advisable. In practice, all current assets take positivevalue, because the firm seeks to reduce working capital riskThe risk return trade-off involve in managing the firms liquidity isillustrated in following example:

Firm B has invested in marketable securities which has been financedwith equity. Firm A has current Ratio of 2.5:1 and ROI is 10% while FirmB has current Ratio of 3:1 and ROI is 9.66%

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Balance sheets A B

Rs. Rs.

1 Cash 500.00 500.00

2Marketblesecurities(9%) 5,000.00

3 Account receivables 9,500.00 9,500.00

4 Inventories 15,000.00 15,000.00

5 Current assets 25,000.00 30,000.00

6 Net fixed assets 50,000.00 50,000.00

7 Total 75,000.00 80,000.00

8 Current Liablities 10,000.00 10,000.00

9 Long term debt 15,000.00 15,000.00

10 Equity Capital 50,000.00 55,000.00

11 Total 75,000.00 80,000.00

12 Current Ratio( 5)/(8) 2.50 3.00

13 Net Working capital 15,000.00 20,000.0014 Net Income 7,500.00 7,725.00

15 ROI In % 10.00 9.66

Thus investing in current Assets and in particular in marketablesecurities does not have favorable effect on firms Liquidity but it hasalso an unfavourable effect on the firms ROI. Thus Risk return Trade-offinvolved in adding marketable securities is just adding one moreliquidity versus reduced profitability.

4. What do you mean by Operating Cycle? Differentiate betweencash conversion Cycle and Operating Cycle with the help of

diagram and illustration.

Ans: Operating cycle is the time period between the acquisition ofinventory and when cash is collected from receivables. In amanufacturing business, operating cycle is the average time that rawmaterial remains in stock less the period of credit taken from suppliers,plus the time taken for producing the goods, plus the time the goodsremain in finished inventory, plus the time taken by customer to pay forthe goods. This can be represented as under:

O = RMCP - DP + WPCP + FGCP + RCP

O is the operating cycleRMCP is raw material conversion periodDP is deferral periodWPCP is work in progress conversion periodFGCP is finished goods conversion period

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RCP is receivable' conversion period

Each stage is influenced by various factors. For example, storage ofraw materials depends on regular availability of raw materials, the lead

time for procurement, the level of safety stock required, possibility orperception of price fluctuations, economics of bulk purchase etc. Thelength of work in process depends on the type of business, consistencyin capacities at various stages of production etc. The duration offinished goods depends on level of competition, pattern of productionand seasonality of demands. The duration of debtors, again dependson competition, discounts offered and efficiency in collection.

Material cost is partly covered by trade credit from suppliers andsuccessive operational activities also involve cash flow. If the flowcontinues without any interruption, operational activities of the company

will also continue smoothly. Movements of cash through the aboveprocesses are called circular flow of cash.

Operating cycle concept is important for management of cash andmanagement of working capital because the longer the operating cyclethe more financial resources the company needs. Therefore, themanagement has to remain cautious that the operating cycle should notbecome too long.

Operating Cycle

= Inventory + Receivables PayablesConversion period Conversion period deferral

period

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Cash conversion cycle is the time between cash disbursement andcash collection.

An estimate of the average time between when a firm pays cashfor its inventory purchases and when it receives cash for its sales;the average number of days of sales that firm must financeoutside the use of trade credit.

Operating cycle is long and a number of steps could be taken to shortenthis operating cycle. Debtors could be cut by a quicker collection ofaccounts. Finished goods could be turned over more rapidly, the level ofraw material inventory could be reduced or the production periodshortened. The operating cycle help in assessing the needs of working

capital accurately by determining the relationship between debtors andsales, creditors and sales and inventory and sales. Even requirement ofextra working capital can be guessed from such estimate.

The above figure would reveal that operating cycle is the time thatelapses between the cash outlay and the cash realisation by the sale offinished goods and realisation of sundry debtors. Thus cash used inproductive activity, often some time comes back from the operatingcycle of the activity. The length of operating cycle of an enterprise is thesum of these four individual stages i.e. components of time.

The operating cycle can be calculated for a period as under:

1. RMCP = Average Raw material stock X 360Total Raw material consumption

Less: Period of credit granted by supplier (DP)

Inventory period

Inventorysold

Cashreceived

Inventorypurchased

Accounts receivable period

Operating cycle (OC)

Cash Conversion Cycle (CCC)

Cash paid forinventory

Accounts payable period

Time

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= Average level of creditors X 360 Total credit purchase

2. WPCP = Average work in progress X 360 Total cost of production

3. FGCP = Average stock of finished goods X 360 Total cost of good sold

4. RCP = Average debtors X 360 Total Credit sales

Total Net operating cycle ________XXX__

ILLUSTRATIONS

Example No. 1

Using the following data, calculate operating cycle for UrviInternational Limited: (360 days assumed)

Particulars Rs.

Sales 36,00,000

Total cost of production 24,00,000

Purchases 7,20,000

Average Stock of raw material 72,000

Average Work in progress 1,08,000Average Stock of Finished goods 2,16,000Average creditors 90,000

Average debtors 3,60,000

SolutionOperating cycle for Urvi International Limited

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STUDY -6 FTFM

1. RMCP = Average Raw material stock X 360 = 72,000 X 360= 36 days

Total Raw material consumption 7,20,000

Less: Period of credit granted by supplier (DP)= Average level of creditors X 360 = 90,000 X 360(= 45 days)

Total credit purchase 7,20,000

2. WPCP = Average work in progress X 360 = 1,08,000 X 360= 16 days

Total cost of production 24,00,000

3. FGCP = Average stock of finished goods X 360 = 2,16,000 X 360

= 32 days Total cost of good sold24,00,000

4. RCP = Average debtors X 360 = 2,16,000 X 360 =22 days Total Credit sales 36,00,000

Net operating cycle = 36 days 45 days +16 days +32 days + 22daysNet operating cycle = 61 days.

5. What are the factors which influences the determination of

working capital?Ans:Factors Influencing Working CapitalIn addition to the working parameters peculiar to a company that determine thequantum of required working capital, the following factors are also equally important:

1. Nature of Business: A companys working capital requirements aredirectly related to the types of business operations. A company thatsells a service primarily on a cash basis can carry there business withless amount of working capital. Public utility service (like railwaycompanies) as compared to manufacturing concerns requires a lesseramount of working capital. A larger amount of working capital isrequired for trading or merchandising institutions.

2. Seasonal Fluctuations: A number of industries manufactures andsell goods only during seasons. For example sugar industrymanufactures sugar between December and April, therefore theworking capital requirement will be more during this period ascompared to any other period.

3. Production Policies: The quantum of working capital is determinedby production policy. If the firm is using labour intensive techniquesworking capital requirement will be more. Suppose a firm is making a

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product for which demand is seasonal, what kind of policy shouldfollowed in such cases? As a matter of policy, the choice will rest onthe one hand, and maintaining a steady rate of production andpermitting stocks of inventories to build up during off season periods,on the other. In the first instance, inventories are kept to minimum

levels but the production manager must shoulder the burden ofconstantly adjusting his working staff; in the second, the uniformmanufacturing rate avoids fluctuations of production schedules, butenlarged inventory stocks create special risks and costs. In case ofhighly automatic plant requirement of working capital will be more.

4. Credit Policy: A business unit, making purchase on credit basis andselling its finished products on cash basis, will require lower amountof working capital than a concern having no credit facilities and whichmay further be forced to grant credit to its customers.

5. Growth: As a company expands, it is logical to expect that largeramounts of working capital will be required to avoid interruptions to

the production sequence.

6. Position of the Business Cycle: In addition to the long-termsecular trend, the recurring movements of the business cycleinfluence working capital changes. In periods of the boom anddepression, more working capital is needed than during the otherstages of cyclical fluctuations. For arriving at a satisfactory workingcapital position in time of prosperity the firm should conserve current

capital by avoiding wasteful expenditure. When inflationary pressurehas been created during a period of emergency like a war,unnecessary hoarding should be avoided because such periods ofrising prizes are temporary. During a period of recession, productionis disturbed due to scarcity of materials. The current assets should beconverted into cash without creating new financial obligations byborrowing at a high rate of interest. During periods of long lastingdepression, excessive stocks are accumulated and fund of thecompanies are locked up. As a result, any addition to working capitalby way of borrowing is undesirable. Attempts should be directed toconvert current assets into cash.

7. Size of business unit: It is an important factor for determining theproportion of working capital. The general principal in this connectionis that the bigger the size of the unit, the more will be the amount ofworking capital required. But it is quite likely that the bigger sizedbusiness unit, i.e., a consumers goods industry may require a largeramount of fixed capital than working capital.

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8. Dividend Policy: A desire to maintain an established dividend policymay affect the volume of working capital, or changes in workingcapital may bring about an adjustment of dividend policy. In eitherevent, the relationship between dividend policy and working capital iswell established, and very few companies ever declare a dividend

without giving consideration to its effect on cash and their needs forcash.9. Operating Efficiency of the company: Operating efficiency of a company plays

a major role in working capital management. An efficient company will have ashorter manufacturing period, long credit terms available from suppliers andminimal customers credit outstanding. If this is achieved then the quantum ofworking capital required will be naturally reduced.

10. Rapidity of Turnover: A company having high rate of turnover will needless amount of working capital as compared to company which haslow turnover. For example; in case of jewelers the turnover is veryslow, therefore his working capital requirement will be more.

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10 pointers working capital

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