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Working Capital Management &

Cash Flow Analysis

Anjana Vivek Ketoki Basuwww.venturebean.com www.finexsolutions.comanjana@venturebean.com

info@finexsolutions.com

Working Capital Cycle

Working Capital Cycle

What does it measure?– Moment business starts investing in a

business to the time when business receives payment for that product/service.

Why is it important?– A good management of working capital

balances incoming and outgoing to maximize working capital

How can you maximize working capital? Determine time lag between each

item Identify items with long time lag Reduce time lag Cycle is critical for success in some

types of business. Eg. - retail, consumer goods and consumer goods manufacturer

Working capital changes due to

Changes in operational activities/ level of sales

Changes in company policy-internal Changes in business environment-

external

Factors affecting working capital Nature of business Production cycle Business cycle and operations-

efficiency Production policy Credit policy

How to calculate working capital? Gross working capital

– Total of current assets i.e. Net working capital

– Total current assets less total current liabilities

Current Assets- inventory, cash and debtorsCurrent Liabilities- dues to suppliers, employee

Caselet- DHS

DHS a hypothetical business with current assets of Rs.50, 000 and current liabilities of Rs.25, 000, has working capital of Rs.25 000 (Rs.50, 000 minus Rs.25 000).

The business has Rs. 2 of current assets for every Re. 1 of current liabilities.

DHS’s working capital or current ratio is expressed as 2:1 which appears to be adequate, safe and liquid.

Real Life Situations

Situation 1

Current Assets Current Liabilities-Rs. 100,000 Rs. 50,000

Working Capital Ratio = 2:1- Safe and adequate

Real Life Situations

Situation 2

Current Assets = Rs. 100,000 = Current LiabilitiesWorking Capital Ratio = 1:1- Too low for businesses. But often the case in organizations with high turnover and low debtors- eg. supermarket

Real Life Situations Situation 3

Current AssetsRs. 40,000 Current Liabilities Rs. 50,000

Working Capital Ratio = 0.8 :1Very low for businesses. Company has only 80% assets to cover its liabilities. Not recommended. Can arise in companies with unpredictable cash flows.

Cash Flow Movement of money in and out of your

business Cycle of the inflow and outflow of cash

determines your business solvency Cash flow analysis:

– To study the inflow and outflow of cash of the business to maintain adequate cash balance

– Study each component of cash cycle and determine how to increase efficiency

Cash flow: importance

Similar to a bank statement- deposits and withdrawals

Importance is not only cash flow but also timing

Cash FlowFrom Operations Principal revenue producing activities and others

that are not investing or financing

From Investing Acquisition and disposal of long-term assets and

other investments which are not short term

From Financing Result in changes in equity and borrowings of

enterprise

Cash from operational activities

Earning from operations before deducting income tax, depreciation and amortization

Deduct income tax Adjust for movement in working capital

– Increase in Debtors/ Inventory – money has not come in-reduces cash

– Decrease in Debtors/ Inventory- money has been collected-increases cash

– Increase in Supplier dues- money has not gone out- cash balance is high

– Decrease in Supplier dues- payment made- cash reduced

Cash from investing activities

Assets purchased- money spent- cash balance down

Assets sold- money comes in to increase cash balance

New Investments made- money spent- decreases cash balance

Investments liquidated- money comes in to increase cash balance

Assets- Computers, Software, Furniture, BuildingInvestments-Bonds, Fixed Deposits

Cash from financing activities New loan taken- money comes in –

cash balance goes up Loan repaid- payment made- cash

moves out Interest paid on loan- cash balance

reduces Capital contribution- inflow of cash

Quick solutions… to improve cash flow Invoice without delay Ask for an advance payment upfront-

before you start a project Introduce rewards for quick

payments Make all efforts to collect sales

promptly Pay all your bills only when due

Close the cash flow gap Cash flow gap is when your cash

inflows and cash outflows don’t keep pace with one another, leaving the business with cash shortage

Common among small businesses Monitor closely- if total unpaid bills >

sales due at the end of each month

Cash flow need

– Projection of future cash flow helps – integrate short term and long term needs– to anticipate surplus and deficits to plan– helps compare actuals with budgets– to make sure funds are available when needed

Immediate solutions in cash crunch situations– Increase borrowings, reschedule plans &

payments, in worst case distress sale of assets

Inventories

Raw material Work in progress Finished goods

Inventories

Inventory balance to be maintained also depends on:

Projected sales for each product Availability of raw material,

supplies Storage space available Life of stock, based on expected

obsolescence, deterioration

Accounts receivable: Motives for credit

Financial - generally at higher sale price

Operating - eg. when inventory accumulates

Contracting motive – eg. in warranty period

Marketing motive - to push sales

Control on trade credit Mental attitude to credit control Clear practices as company policy, to be

understood by executives, suppliers, customers

Check on potential customer Continuously review limits set for

customer Invoice promptly, clearly Consider charging penalty, as per invoice

Control on trade credit Determine whether invoices are paid

according to sales terms Status of unshipped orders to be known Determine total outstanding in any

customers account Monitor total debtors accounts very

closely Develop close links with large

customers

Some possible problem areas Single large or key customer Improper credit judgement Poor collection procedures Lax enforcement of credit terms Delay in invoicing Errors in invoicing Customer dissatisfaction

Accounts payableTrade credit vs bank credit Relatively shorter (30 - 90 days) Usually unsecured, more lenient in

lending credit Amounts involved with individual

suppliers usually smaller

Dues to creditors Purchase authorisation in company Purchase quantities to be planned based

on financial & non-financial requirements Alternate sources of supply to be

identified, shop for best deals, credit terms and dependence on single supplier

If supplier defaults in delivery, what is the impact

Dues to creditors Purchase authorisation in company Purchase quantities to be planned based

on financial & non-financial requirements Alternate sources of supply to be

identified, shop for best deals, credit terms and dependence on single supplier

If supplier defaults in delivery, what is the impact

Caselet: MainLab - Cash FlowMainLab develops pharmaceutical products and has several patents to its credit. The company has grown fast, chiefly due to new products being developed and sold. The company does not pay dividend, but has a high P/E ratio. Due to very rapid growth, the company has experienced cash shortages and wants to improve this.

Caselet: MainLab - Cash FlowStrategies suggested: Customers to pay within 30 days as against 60 days now allowed

Reduce R&D expenditure by 20%.

Evaluate this as A short term creditor An investor

Caselet: MachCo – Cur. RatioMachCo owns many retail stores selling machinery and hardware. The current ratio in October is 1.7:1. This is lower than that of its competitors. To get better credit terms from suppliers, the company wants to improve this ratio to at least 2:1 by year end in December

Caselet: MachCo – Cur. Ratio

Strategies suggested: Pay some current liabilities Purchase inventory on account Offer debtors discount on quick payment Evaluate whether current ratio will increase or

decrease in each case Propose some ethical steps to increase the

current ratio before year end.

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Thank you