working capital management handout emerg
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Working Capital Management
By CA Shubha Ganesh Moneyshiksha www.shubhaganesh.com
www.moneyshiksha.co.in
Learning Objectives
Importance of working capital in a small business
Differentiate between long term and
short term assets
Components of working capital
Working capital cycle of a small business
Managing the big three
Identify working capital stress signals
Theoretically
Working Capital is stated in two ways:
Gross Working capital - Sum of all current assets
Net Working capital - Current assets less current liabilities
Practically
Apart from one time buying land, machinery, furniture and other fixed assets for manufacturing your firm’s products, you will need short –term assets and short –run resources to run the firm
This is called working capital
Need for Working capital
Working capital is required to ensure that a firm has sufficient funds to pay maturing short-term debt, upcoming operational expenses and for regular operations.
Current Assets
Those assets which in ordinary course of business will be converted to cash within one year without losing value or without disrupting the operations of the firm
The differentiator
Time dimension
Short term asset lose their identity very quickly say within a year/operating cycle
Time factor not crucial for decision making
Current Assets Inventories
Raw material
Work in progress
Finished goods
Sundry debtors
Loans and advances
Cash and bank balances
Other current assets
Current Liabilities
Current liabilities are those liabilities which are intended at their inception, to be paid within one year out of current assets or profits of the firm
Sundry creditors
Borrowings (short term)
Commercial banks
Others
Provisions
Managing working capital
This involves decisions regarding:
Stock levels
Debtor levels
Cash levels
Creditors
Working capital management
Decisions regarding working capital should be taken very carefully as they affect either:-
Profitability of the firm
Liquidity of the firm
Increases or decreases the relative risk of the firm
Why manage them?
Working capital management should therefore aim at striking a balance such that there is an optimum amount of short term assets so that there is sufficient liquidity to pay the liabilities at minimum cost
Liquidity a primary concern
A company can be endowed with assets and profitability but is short of liquidity if its assets
cannot readily be converted into cash
The key issue in working capital management is to avoid running out of cash
Learning to balance
If the size of current assets are large the comfort zone increases and liquidity increases but profits will go down as funds are kept idle. They have a cost too
If the size of current assets is too small profits will improve but liquidity will decline and you are exposed to technical insolvency
Working Capital
Cash flow in a business is:
uncertain
asynchronous
Buffers
There is a need for buffers
To manage the mismatch
Decouple sourcing and production
Makes activity smooth, efficient
Types of capital
Permanent
Temporary
Working capital mix
Hedging
Conservative
Mix of both
• Choice will be based on trade off of risk vs. cost
Sources of working capital
Bank credit
Trade credit
Factoring
Commercial paper
Cost of these funds
Determinants of working capital requirements
Nature of business
Time taken for production
Availability of raw materials
Production policy
Credit policy
Operating efficiency
Approximate working capital required can be pre-determined
Determination of working capital required
Caselet -1
Working capital cycle
The daily flow of resources through a firm's short term assets and liabilities
Operating cycle
The continuing flow from cash to suppliers to inventory, to accounts receivable and back to cash is called the operating cycle
Timeline
OG1 RG15 PI40 SG218 DG221 SI230 CP280
Cash flow chart
Cash
Accts. Payable
Cash Purchases
Inventory
Cash Sales
Accounts Receivable
L
L
Cash flow
There is a continuous flow of cash in a business
Cash inflows and outflows do not match
Cash flows in and out of business from sale of goods to purchase of inventory
They happen in stages
If all stages were completed instantaneously there would be no need for working capital
Cash flow cycle
The time lag between paying the suppliers and receiving payment from customers
The time lag between each of these is called cash cycle Conversion of cash to inventory
Conversion of inventory to receivables
Conversion of receivables to cash
Cash conversion cycle
Exercise
Garfield cat foods Ltd. On an average collects debtors after 45 days, holds inventory for 75 days and pays creditors in 30 days. It’s total spend Rs. 120 lakhs annually at constant rate. It can earn 10% if it invests this money.
Find-cash cycle, cash turnover, minimum cash balance and savings if inventory holding period is 45 days
Answer
Cash cycle-45+75-30=90 days, 3 months
Cash turnover-12mths/3mths=4
Minimum working capital-120/4=Rs.30 lakhs
New cash cycle-45+45-30=60 days, 2 months
12/2=6
120/6=Rs. 20 lakh
Savings=10lakhs*10%=Rs.1 lakh
Thank you