Working Capital Management

WORKING CAPITAL

Current assets – Current liabilities It measures how much in liquid assets a company has

available to build its business. A short term loan which provides money to buy earning

assets. Allows to avail of unexpected opportunities. Positive working capital is required to ensure that a firm

is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash.

WORKING CAPITAL

An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.

Working Capital Management

Decisions relating to working capital and short term financing are referred to as working capital management. Short term financial management concerned with decisions regarding to CA and CL.

Management of Working capital refers to management of CA as well as CL.

If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

Working Capital Management

The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Businesses face ever increasing pressure on costs and financing requirements as a result of intensified competition on globalised markets. When trying to attain greater efficiency, it is important not to focus exclusively on income and expense items, but to also take into account the capital structure, whose improvement can free up valuable financial resources

WORKING CAPITAL MANAGEMENT

Active working capital management is an extremely effective way to increase enterprise value. Optimising working capital results in a rapid release of liquid resources and contributes to an improvement in free cash flow and to a permanent reduction in inventory and capital costs, thereby increasing liquidity for strategic investment and debt reduction. Process optimisation then helps increase profitability.

WORKING CAPITAL MANAGEMENT

The fundamental principles of working capital management are reducing the capital employed and improving efficiency in the areas of receivables, inventories, and payables.

Why working Capital is important?

Investment in CA represents a substantial portion of total investment.

Investment in CA and level of CL have to be geared quickly to changes in sales.

Concepts of Working Capital

Gross Working Capital Net working Capital

Gross Working Capital

Total Current assets Where Current assets are the assets that

can be converted into cash within an accounting year & include cash , debtors etc.

Referred as “Economics Concept” since assets are employed to derive a rate of return.

Net Working Capital

CA – CL Referred as ‘point of view of an

Accountant’. It indicates liquidity position of a firm &

suggests the extent to which working capital needs may be financed by permanent sources of funds.

CONSTITUENTS OF WORKING CAPITAL

CURRENT ASSETS Inventory Sundry Debtors Cash and Bank Balances Loans and advances

CURRENT LIABILITIES Sundry creditors Short term loans Provisions

Characteristics of Current Assets

Short Life Span

I.e. cash balances may be held idle for a week or two , thus a/c may have a life span of 30-60 days etc.

Swift Transformation into other Asset forms

I.e.each CA is swiftly transformed into other asset forms like cash is used for acquiring raw materials , raw materials are transformed into finished goods and these sold on credit are convertible into A/R & finlly into cash.

Matching Principle

If a firm finances a long term asset(like machinery) with a S-T Debt then it will have to be periodically finance the asset which will be risky as well as inconvenient.

i.e. maturity of sources of financing should be properly matched with maturity of assets being financed.

Thus Fixed Assets & permanent CA should be supported with L-T sources of finance & fluctuating CA by S-T sources.

MATCHING PRINCIPLE

Need for Working Capital

As profits earned depend upon magnitude of sales and they donot convert into cash instantly, thus there is a need for working capital in the form of CA so as to deal with the problem arising from lack of immediate realisation of cash against goods sold.

This is referred to as “Operating or Cash Cycle” . It is defined as “The continuing flow from cash to

suppliers, to inventory , to accounts receivable & back into cash “.

Need for Working Capital

Thus needs for working capital arises from cash or operating cycle of a firm.

Which refers to length of time required to complete the sequence of events.

Thus operating cycle creates the need for working capital & its length in terms of time span required to complete the cycle is the major determinant of the firm’s working capital needs.

Operating or Cash Cycle

1. Conversion of cash into inventory

2. Conversion of inventory into Receivables

3. Conversion of Receivables into Cash

OPERATING CYCLE

Receivables  

  

InventoryCash

Phase 1

Phase 2

Phase 3

TYPES OF WORKING CAPITAL

PERMANENT WORKING CAPITAL VARIABLE WORKING CAPITAL

PERMANENT WORKING CAPITAL

THERE IS ALWAYS A MINIMUM LEVEL OF CA WHICH IS CONTINOUSLY REQUIRED BY A FIRM TO CARRY ON ITS BUSINESS OPERATIONS.

THUS , THE MINIMUM LEVEL OF INVESTMENT IN CURRENT ASSETS THAT IS REQUIRED TO CONTINUE THE BUSINESS WITHOUT INTERRUPTION IS REFERRED AS

PERMANENT WORKING CAPITAL.

VARIABLE WORKING CAPITAL

THIS IS THE AMOUNT OF INVESTMENT REQUIRED TO TAKE CARE OF FLUCTUATIONS IN BUSINESS ACTIVITY OR NEEDED TO MEET FLUCTUATIONS IN DEMAND CONSEQUENT UPON CHANGES IN PRODUCTION & SALES AS A RESULT OF

SEASONAL CHANGES.

DISTINCTION

PERMANENT IS STABLE OVER TIME WHEREAS VARIABLE IS FLUCTUATING ACCORDING TO SEASONAL DEMANDS.

INVESTMENT IN PERMANENT PORTION CAN BE PREDICTED WITH SOME PROFITABILITY WHEREAS

INVESTMENT IN VARIABLE CANNOT BE PREDICTED EASILY.

WHILE PERMANENT IS MINIMUM INVESTMENT IN VARIOUS CA , VARIABLE IS EXPECTED TO TAKE CARE FOR PEAK IN BUSINESS ACTIVITY.

DISTINCTION

WHILE PERMANENT COMPONENT REFLECTS THE NEED FOR A CERTAIN IRREDUCIBLE LEVEL OF CURRENT ASSETS ON A CONTINOUS AND UNINTERRUPTED BASIS , THE TEMPORARY PORTION IS NEEDED TO MEET SEASONAL & OTHER TEMPORARY REQUIREMENTS.

ALSO PERMANENT CAPITAL REQUIREMENTS SHOULD BE FINANCED FROM L-T SOURCES , S-TFUNDS SHOULD BE USED TO FINANCE TEMPORARY WORKING CAPITAL NEEDS OF A FIRM,

OPERATING ENVIRONMENT OF

WORKING CAPITALCHAPTER 2

Monetary and Credit Policies

Monetary policy is the process by which the govt.,central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy involves variations in money supply , interest rates , lending by commercial banks etc.

Credit Policy Credit gives the customer the opportunity to buy goods and

services, and pay for them at a later date. Clear, written guidelines that set (1) the terms and conditions for supplying goods on credit , (2) customer qualification criteria (3) procedure for making collections , and (4) steps to be taken in case of customer delinquency . Also called

collection policy. Where delinquency means Failure to repay an obligation when

due or as agreed. Thus in consumer installment loans, missing two successive payments will normally make the account delinquent

Advantages of credit trade

Usually results in more customers than cash trade. Can charge more for goods to cover the risk of bad debt. Gain goodwill and loyalty of customers. People can buy goods and pay for them at a later date. Farmers can buy seeds and implements, and pay for them

only after the harvest. Stimulates agricultural and industrial production and

commerce. Can be used as a promotional tool. Increase the sales.

Disadvantages of credit trade

Risk of bad debt. High administration expenses. People can buy more than they can

afford. More working capital needed. Risk of Bankruptcy.

Instruments of Monetary Policy in India

Money Supply Bank Rate Reserve Ratios Interest Rates Selective Credit Controls Flow of Credit

Money Supply

This is the sum total of money public funds and can be used for settling transactions to buy and sell things and make other payments constitutes the money supply of a nation.

Money supply = Notes and coins with public + Demand deposits with Commercial papers

Bank Rate

Standard rate at which bank is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under Reserve bank of India Act,1934.

The rate of interest charged by central bank on their loans to commercial banks is called bank rate(Discount rate).

An increase in bank rate makes it more expensive for commercial banks to borrow . This exerts pressure to bring about the rise in interest rates (lending rates) charged by commercial banks on their lending to public. This leads to a general tightening in economy.

Whereas decrease in bank rate has the opposite effect and leads to general easing of credit in the economy.

RESERVE REQUIREMENTS The reserve requirement (or required reserve ratio) is a bank

regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault(vault cash), or with a central bank.

The reserve ratio is sometimes used as a tool in the monetary policy, influencing the country's economy, borrowing, and interest rates .Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they prefer to use open market operations to implement their monetary policy

RESERVE REQUIREMENTS

Thus central bank makes it legally obligatory for commercial banks to keep a certain minimum percentage of deposits in reserve.

These are of 2 types:-

1. Cash reserves

2. Liquidity reserves

CRR

CASH RESERVE RATIO THIS IS DEFINED AS A cash reserve

ratio (or CRR) is the percentage of bank reserves to deposits and notes. The cash reserve ratio is also known as the cash asset ratio or liquidity ratio.

STATUTORY LIQUIDITY RATIO

Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form:

Cash Gold valued at a price not exceeding the

current market price, Unencumbered approved securities (G Secs or

Gilts come under this) valued at a price as specified by the RBI from time to time.

STATUTORY LIQUIDITY RATIO

The quantum is specified as some percentage of the total demand and time liabilities ( i.e. the liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one months time due to maturity) of a bank. This percentage is fixed by the Reserve Bank of India. The maximum and minimum limits for the SLR are 40% and 25% respectively.

Following the amendment of the Banking regulation Act(1949) in January 2007, the floor rate of 25% for SLR was removed. Presently the SLR is 24% with effect from 8 November, 2008.

The objectives of SLR are: To restrict the expansion of bank credit. To augment the investment of the banks in Government securities. To ensure solvency of banks. A reduction of SLR rates looks eminent to

support the credit growth in India.

INTEREST RATES

This is generally done by stipulating min. rates of interest for extending credit against commodities covetred under selective credit control.

Also, concessive or ceiling rates of interest are made applicable to advances for certain purposes ao to certain sectors to reduce the interest burden and thus facilitate their development.

Further obj. behind fixing rates on deposits are to avoid unhealthy competition amongst the banks for deposits and keep the level of deposit rates in alignment with lending rates of banks for deposits.

Selective Credit Controls

These are Qualitative instruments which are aimed at affecting changes in the availability of credit with respect to particular sectors of the economy.

Thus selective controls are called selective because they are aimed at movement of credit towards selective sectors of the economy.

Selective Credit Controls

The general instruments such as Reserve ratios, Bank rate and open market operations.

They are called so because they influence the nation’s money supply and general availability of credit.

Quantitative instruments are called quantitative because they affect the total volume(quantity) of money supply and credit in the country.

Selective Credit Controls

The most widely used qualitative techniques are selective control and moral suasion.

While the general credit controls operate on the cost and total volume of credit , selective credit controls relate to tools available with the monetary authority for regulating the distrubution or direction of bank resources to particular sectors of economyin accordance with broad national priorities considered necessary for achieving the set.

MORAL SUASION

IT IMPLIES THE CENTRAL BANK EXERTING PRESSURE ON BANKS BY USING ORAL AND WRITTEN APPEALS TO EXPAND OR RESTRICT CREDIT IN LINE WITH ITS CREDIT POLICY.

DETERMINATION OF WORKING CAPITAL NEEDS

CHAPTER 3

Different approaches in determination of working capital

Industry norm approach Economic modeling approach Strategic choice approach

INDUSTRY NORM APPROACH

THIS APPROACH IS BASED ON THE PREMISE THAT EVERY COMPANY IS GUIDED BY THE INDUSTRY PRACTICE.

LIKE IF MAJORITY OF FIRMS HAVE BEEN GRANTING 3 MONTHS CREDIT TO A CUSTOMER THEN OTHERS WILL HAVE TO ALSO FOLLOW THE MAJORITY DUE TO FEAR OF LOSING CUSTOMERS.

ECONOMIC MODELLING APPROACH

TO ESTIMATE OPTIMUM INVENTORY IS DECIDED WITH THE HELP OF EOQ MODEL.

STRATEGIC CHOICE APPROACH

THIS APPROACH RECOGNISES THE VARIATIONS IN BUSINESS PRACTICE AND ADVOCATES USE OF STRATEGYIN TAKING WORKING CAPITAL DECISIONS.

THE PURPOSE BEHIND THIS APPROACH IS TO PREPARE THE UNIT TO FACE CHALLENGES OF COMPETITION & TAKE A STRATEGIC POSITION IN THE MARKET PLACE.

STRATEGIC CHOICE APPROACH

THE EMPHASIS IS ON STRATEGIC BEHAVIOUR OF BUSINESS UNIT.THUS THE FIRM IS INDEPENDENT IN CHOOSING ITS OWN COURSE OF ACTION WHICH IS NOT GUIDED BY THE RULES OF INDUSTRY,

Determinants of working capital

General nature of business Production cycle Business cycle Credit policy Production policy Growth and expansion Profit level Operating efficiency