WORKING CAPITAL FINANCE

CA. SANJAY

KOTHARI

DEFINITION

� Working Capital refers to that part of the firm’s

capital, which is required for financing short-

term or current assets such as cash marketable

securities, debtors and inventories.

� Funds thus, invested in current assets keep� 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.

FACTORS DETERMINING WORKING

CAPITAL

� Nature of the Industry

� Demand of Industry

� Cash requirements

� Nature of the Business

� Production Cycle

� Credit control

� Inflation or Price level changes

� Profit planning and controlBusiness

� Manufacturing time

� Volume of Sales

� Terms of Purchase and Sales

� Inventory Turnover

� Business Turnover

� Business Cycle

� Current Assets requirements

control

� Repayment ability

� Cash reserves

� Operation efficiency

� Change in Technology

� Firm’s finance and dividend policy

� Attitude towards Risk

WORKING CAPITAL CYCLE

Cash

RMDebtors RM

WIP

FG

Sales

Debtors

TIME AND MONEY CONCEPTS IN

WORKING CAPITAL CYCLE

� Each component of working capital (namelyinventory, receivables and payables) has twodimensions ........TIME ......... and MONEY, when itcomes to managing working capital.

� You can get money to move faster around the cycle orreduce the amount of money tied up. Then, businessreduce the amount of money tied up. Then, businesswill generate more cash or it will need to borrow lessmoney to fund working capital.

� As a consequence, you could reduce the cost of bankinterest or you'll have additional free money availableto support additional sales growth or investment.

� Similarly, if you can negotiate improved terms withsuppliers e.g. get longer credit or an increased creditlimit, you effectively create free finance to help fundfuture sales.

If you Then ......

Collect receivables

(debtors) faster

You release cash from the

cycle

Collect receivables

(debtors) slower

Your receivables soak up

cash

Get better credit (in terms You increase your cashGet better credit (in terms

of duration or amount)

from suppliers

You increase your cash

resources

Shift inventory (stocks)

faster

You free up cash

Move inventory (stocks)

slower

You consume more cash

TYPE OF WORKING CAPITAL

� Concept Basis

� Gross WC

� Net WC

� Time Basis� Time Basis

� Permanent/Fixed WC

� Regular WC

� Reserve WC

� Temporary/variable WC

� Seasonal WC

� Special WC

SOURCES OF WORKING CAPITAL

� Sources of working capital are:

� Owned fund (Equity, Reserves, etc.)

� Bank borrowings(Cash Credit, Packing Credit, B/D, L/C)

� Sources of additional working capital include the � Sources of additional working capital include the

following:

� Existing cash reserves

� Profits (when you secure it as cash !)

� Payables (credit from suppliers)

� New equity or loans from shareholders

� Bank overdrafts or lines of credit Long-term loans

METHODS OF ASSESSMENT OF WORKING

CAPITAL

� TURNOVER METHOD

� Mainly used for small trading companies

� Not appropriate for manufacturing and big trading companies

� CASH BUDGET SYSTEM� CASH BUDGET SYSTEM

� Mainly used for service sector companies

� Cash inflow – Cash outflow = Bank finance in form of WC

� TONDON COMMITTEE RECOMMENDATIONS

� Out of 3 methods recommended, method II also known as

Maximum Permissible Bank Finance (MPBF) is mainly used by the

banks for assessment of WC finance

CREDIT MONITORING ARRANGEMENT

(CMA)

CMA data is a tool used by the bankers to assess the

requirement of working capital. It is divided into six parts as

follows:

Form I Particulars of Existing & Proposed LimitsForm I Particulars of Existing & Proposed Limits

Form II Operating Statement

Form III Analysis of Balance Sheet

Form IV Comparative Statement of Current Assets & Current

Liabilities

Form V Computation of Maximum Permissible Bank Finance (MPBF)

Form VI Funds Flow Statement

KEY RATIO LEVELS

11

PARTICULARS LOW RISK MEDIUM RISK HIGH RISK

Current Ratio > 1.40 1.20 - 1.40 < 1.20

TOL/TNW < 2.00 2.00 - 3.50 < 3.50

Interest Coverage > 3.50 2.00 - 3.50 < 2.00Interest Coverage > 3.50 2.00 - 3.50 < 2.00

PAT/SALES% > 10.00 4.00 - 10.00 < 4.00

Inventory (No. of days) < 60 60 - 90 > 90

Debtors (No. of days) < 45 45 - 90 > 90

Debt – Equity Ratio < 1.25 1.25 - 1.75 > 1.75

DSCR (For TL) > 2.00 1.25 - 2.00 < 1.25

FORECASTING/ESTIMATION OF WORKING

CAPITAL REQUIREMENT

Factors to be considered

� Total costs incurred on materials, wages and overheads

� The length of time for which raw materials remain instores before they are issued to production.

� The length of the production cycle or WIP, i.e., the timetaken for conversion of RM into FG.taken for conversion of RM into FG.

� The length of the Sales Cycle during which FG are to bekept waiting for sales.

� The average period of credit allowed to customers.

� The amount of cash required to pay day-to-day expensesof the business.

� The amount of cash required for advance payments ifany.

� The average period of credit to be allowed by suppliers.

� Time – lag in the payment of wages and other overheads

WORKING CAPITAL PRODUCTS

� Fund based

� Domestic

� Cash Credit

� Overdraft facility

� Bill Discounting

� Export

� Preshipment Credit

� Post shipment Credit

� Non-fund based

� Letter of credit

� Bank Guarantee

SPECIAL SITUATIONS

� CYCLICAL PRODUCTION/SALES

� PHASED EXPANSION PROGRAMS

� EXPANSION PROGRAMS WITH ENHANCEMENT IN EXISTING LIMITS

� MAJOR ORDERS� MAJOR ORDERS

� ENHANCEMENT DURING THE YEAR

� SHORT TERM FUND USED FOR ACQUISITION OF LONG TERM ASSETS

� DRAWING POWER NOT ALLIGNED TO MPBF

� DEVALUATION / EROSION OF CURRENT ASSETS

STRUCTURED WORKING CAPITAL

PRODUCTS

� Commercial Paper

� Corporate Loan

� Suppliers/ Buyers Credit

Securitisation of receivables� Securitisation of receivables

� Factoring

� Forfeiting

IMPORTANCE OF ADEQUATE WORKING

CAPITAL

�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.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.

DISADVANTAGE OF INADEQUATE

WORKING CAPITAL

� Idle funds, non-profitable for business, poor ROI.

� Unnecessary purchasing & accumulation of inventories overrequired level.

� Excessive debtors and defective credit policy, higher incidence ofB/D.

� Overall inefficiency in the organization.

When there is excessive working capital, Credit worthiness� When there is excessive working capital, Credit worthinesssuffers.

� 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.

� Due to low rate of return on investments, the market value ofshares may fall.

OVERTRADING

Trying to operate without adequate working capital. Itis often caused by an expansion in credit sales, andthus in trade receivables. This causes a shortage ofcash.

Early warning sign of overtrading include:� Pressure on existing cash

Exceptional cash generating activities e.g. offering high� Exceptional cash generating activities e.g. offering highdiscounts for early cash payment

� Bank overdraft exceeds authorized limit� Seeking greater overdrafts or lines of credit� Part-paying suppliers or other creditors� Paying bills in cash to secure additional supplies� Management pre-occupation with surviving rather than

managing� Frequent short-term emergency requests to the bank (to

help pay wages, pending receipt of a cheque� Declining liquidity ratio

CURING OVERTRADING

Overtrading may be cured or reduced by:

� Borrowing or increasing in capital to increase

current assets

� Sale of non-trading assets

� Tightening terms of credit granted to customers � Tightening terms of credit granted to customers

� Negotiating longer credit terms from major suppliers.

CASH FLOW STATEMENT –BACKBONE OF

GROWTH

� Regular cash flow are the backbone of long-term growthand sustainability. It highlight the strength of thecompany’s business model in meeting its working capitaland capex requirements, coupled with its ability to ensureorderly operations even during a cyclical downturn.

� A company with healthy operating cash flow is in a positionto plough this cash into its projects/wc cycle. It can thusto plough this cash into its projects/wc cycle. It can thusgrow at a steady space, compared to the companies thatmostly rely on external sources to fund their growth. Thiswas on display during the credit crisis last year, which putthe future of companies with poor cash flows in doubt.

� It may be possible that company reports very good earningsbut it may not be generating sufficient cash. Cash flow canbe negative while profitability is positive. Incomestatement and cash flow statement should be analyzed toassess the operational efficiency of the company

SIGN OF POTENTIAL LIQUIDITY

PROBLEMS

� Buildup of inventories and declining inventory

turnover.

� Increases in debt and debt ratios.

� Increases in costs that cannot be passed on.

� Increases in accounts receivables and collection

periods.

� Decline in net working capital and daily cash flows.

NECESSITY TO EFFECTIVELY MANAGE

WORKING CAPITAL

� Working capital doesn't come free -- there is anopportunity cost (returns that it could havegenerated from any other avenue) besides theinterest burden due to the short-term bankborrowings.

� This cost can be substantial during an economicslowdown, when a company's inventories andreceivables rise, bloating current assets. Butcurrent liabilities do not rise in proportion tocurrent assets, since creditors tend to shy awayat such times. It becomes more expensive tofinance working capital, and profits are hit tothat extent.

ADVANTAGE OF EFFECTIVE

MANAGEMENT OF WORKING CAPITAL

� The important thing for a shareholder is how

well the working capital is managed. Though

measured at a point of time, it still says a lot

about how healthy a company's revenues are.

� In last 2 years, companies that managed their

working capital well have reported relatively

strong profits, and their shareholders have been

rewarded with capital appreciation despite an

overall trend of declining share prices. Others,

especially commodity producers and companies

whose products face cyclical demand, have

floundered.

IMPACT ON STOCK VALUATIONS

� As there is a cost associated with working capital, a companythat can generate more revenues from a specified amount ofworking capital than others will eventually be more profitable,with better cash flows and will command superior valuation.

� Most commodity-based companies are capital-intensive and havehigh working capital requirements. Their business is cyclical innature, which puts an additional burden on the working capitalwhen the chips are down. That explains why these companies arenot able to extract a higher valuation from the stock markets.

� Also, with piling receivables and inventories, cash inflows are� Also, with piling receivables and inventories, cash inflows areaffected. This can lead to problems in paying large cash outflowslike interest and dividend. Many companies can do nothing otherthan use their long-term funds to finance this shortfall -- whichcan also lead to falling profits.

� Companies that prefer to maintain low levels of working capitalscore well on working capital turnover ratio (Net sales / Networking capital).Though this level varies with the nature andscale of operations, the stock market attaches a premium tocompanies with low working capital requirements. Likewise, acompany with a high working capital turnover ratio vis-a-vis itspeers tends to get a higher price to earnings (PE) ratio.

CONCLUSION

Any change in the working capital will have an

effect on a business's cash flows. A positive change

in working capital indicates that the business has

paid out cash, for example in purchasing or

converting inventory, paying creditors etc. Hence,converting inventory, paying creditors etc. Hence,

an increase in working capital will have a negative

effect on the business's cash holding. However, a

negative change in working capital indicates lower

funds to pay off short term liabilities (current

liabilities), which may have bad repercussions to

the future of the company.