WORKING CAPITAL MANAGEMENT

MEANING

• Working capital refers to short term funds to meet operating expenses. It refers to the funds which a company must possess to finance its day to day operations. It is concerned with the management of the firms current assets and current liabilities.

Constituents of Current Assets and Current Liabilities• Current Assets- Inventories (Raw

materials , Work - in process, Finished goods), Trade debtors, Loans and advances, Investments, Cash and bank balances

• Current Liabilities- Sundry creditors, Trade advances, short term Borrowings, etc

Needs and Objectives of working Capital• For the purchase of raw materials• To pay wages and salaries• To ensure day to day overhead costs such

as fuel, power and office expenses etc.• To meet selling costs such as packaging

and advertising expenses• To provide credit facilities to the customers• To maintain the inventories of raw

materials, working in process and finished goods.

Concept of Working Capital

There are two concepts of working capital:

•Gross working capital •Net working capital

Gross working capitalThe total of all current assets are termed as gross working capital or circulating capital

Significance of Gross Working Capital

• Optimum investment in Current Assets

• Financing of Current Assets

Net working capitalThe difference between current assets and current liabilities is known as net working capital.

Significance of Net Working Capital • Maintaining liquidity• To decide upon the extent of long term

capital in financing current assets

Kinds of Working Capital

1.Concepts based• Gross Working Capital• Net Working Capital2.Time based• Permanent or regular Working

Capital• Temporary or Variable

Working capital

Permanent or regular Working Capital

• The minimum level of current assets maintained In a firm is known as permanent or regular working capital.

Temporary or Variable Working capital • Any additional working capital apart

from permanent working capital required to support the change in production and sales activities is referred to as temporary or Variable Working capital. In other words an amount over and above the permanent working capital is variable working capital.

Management of working capital

• There are three Dimensions in Managing Working Capital

• It is concerned with the formulation of policies with regard to profitability, risk and liquidity.

• It is concerned with the decision about the composition and level of current assets.

• It is concerned with the decision about the composition and level of current liabilities

Operating and cash conversion cycle

• The time that elapses between the purchase of raw material and the collection of cash for sale is referred as the operating cycle.

Need to maintain balanced Working Capital

For maximization of profit or minimization of working capital cost or to maintain balance between liquidity and profitability there is a need to maintain a balance in working capital. It should not be

• Excessive or • Inadequate

The dangers of excessive working capital• It results in unnecessary

accumulation of inventories which leads to mishandling of inventories, waste, theft and losses.

• It is an indication of defective credit policy and increase in collection period.

• It leads to managerial inefficiency.

The dangers of inadequate working capital• It stagnates growth.• Difficult to implement production• It leads to inefficient utilization of

fixed assets.• It hampers the firm’s goodwill in

the market.

Factors influencing Working Capital

The working capital needs of a firm are influenced by numerous factors. The important ones are:

• Nature of business• Size of the business• Seasonality of operations.• Production policy• Production Cycle Process

Factors influencing Working Capital

• Credit policy or terms of purchase and sales

• Business Cycle• Growth and expansion• Scarce availability of raw material

Factors influencing Working Capital

• Profit level• Dividend policy• Price level changes• Operating Efficiency• Availability of credit

Determination of required working capital

Particulars

A. Estimation of CA1. Raw materials2. Working-in-process Raw materials full costs) Direct Labour (to the extent of

completed stage) Overheads (to the extent of completed

stage)3 Finished goods 4 Debtors5 Cash balance required

Total Current Assets B. Estimation of CL1. Creditors2. Outstanding expenses

B. Total Current liabilities

C. Net Working Capital (A-B) Add contingencies(% on NWC)

D. Working Capital Required

ProblemFrom the following information of XYZ ltd estimate the working capital needed to finance a level of production of 110000 units after adding 10% safety contingencies. The cost per unit Particulars Amount (Rs.)Raw Materials 78Direct Labour 29Overheads 58Total Costs 165Profit 24Selling Price 189

Additional InformationAverage Raw material in stock (one month), Average materials in process (50% completion- ½ month), Average Finished goods in stock (one month), Credit allowed by supplier (one month), Credit allowed to customers (two month(, Time lag in payment of wages ( one&½ weeks ), Time lag in payment of Overheads expenses (one month). ¼ of the sales is on cash basis. Cash balance is expected to be Rs.215000/-.

Working capital policies

By taking into consideration of what should be the ratio of current assets to sales the policies of working capital are Aggressive current asset policy Moderate current asset policy Conservative current asset policy

Aggressive current asset policy

• if the firm follows a highly aggressive current asset policy, it will carry a low level of current assets in relation to sales. An aggressive current asset policy, seeking to minimize the investment in current assets, exposes the firm to greater risk. The firm may not be able to cope with unanticipated changes in the market place and operating conditions. The compensation for higher risk, of course, is higher expected profitability.

Moderate current asset policy• If the firm adopts a moderate current

asset policy, a moderate level of current assets in relation to sales will exist. The moderate level of investment in current assets helps keeping a sufficient amount of resources available for investment in business and maintain adequate liquidity. It results moderate level of risk for the business.

Conservative current asset policy• If the firm pursues a very conservative

current asset policy, it will carry a high level of current assets in relation to sales. Such a policy tends to reduce risk. The surplus current assets under it enable the firm to cope easily with variations in sales, production plans etc. The reduction of risk, however, is also accompanied by the lower expected profitability

Working capital financing Approach

By taking into consideration of what should be the ratio of short term financing to long term financing of the working capital approaches are

• Hedging or matching approach• Conservative approach• Aggressive approach

Hedging or matching approach• In this approach the finance

manager matches the maturity profile of the assets with maturity profile of the sources of finance. Fixed assets and permanent current asset should finance with long term sources and temporary current assets are to be financed with short term sources.

Conservative approach• In this approach the firm depends

more on long term sources of finance. The firm finances its permanent working capital and also a part of its fluctuating working capital with long term financing. Only a small portion of the temporary working capital financed trough short term sources.

Conservative approach

$

Years

Perm C.A.

Fixed Assets

Marketable securities

S-T &Debt

L-T Fin:Stock,Bonds,

Aggressive approach

• In this approach a firm uses more short term sources of financing. Here the temporary as well as a part of the permanent working capital is financed through short term sources.

Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

S-TLoans

L-T Fin:Stock,Bonds,

Choosing the Working Capital Policy• The overall working capital policy adopted

by the firm can be broadly conservative, moderate, or aggressive. Under a conservative overall working capital policy the firm chooses a conservative current asset policy with a conservative current asset financing policy. A moderate overall working capital policy reflects combination of a conservative current asset policy and an aggressive current asset financing policy, or a combination of an aggressive current asset policy and a conservative current asset policy

• An aggressive overall working capital policy consists of an aggressive current asset policy and an aggressive current asset financing policy. An overall conservative working capital policy reduces risk and offers low return. An overall moderate working capital policy offers moderate return accompanied by moderate risk. An overall aggressive working capital policy provides a package of high risk and high return. The choice of an overall working capital policy will depend on the risk disposition of management.

Financing of working capital

There are two types of financing Working Capital

• Long term financing- Shares, Debenture, Ploughing back of profits, Loans from Financial Institutions.

• Short term financing- Accruals, Trade credit, Working Capital advance from commercial Banks, Public Deposits, Short terms loans from Financial Institution, Factoring, Commercial Papers

Sources of Short term FinancingAccrual• The major accrual items are wages

and taxes. These are simply what the firm owes to its employees and to the government. Accruals vary almost spontaneously with the level of activity of the firm

Trade credit

• Trade credit represents the credit extended by the suppliers of gods and services. It is a very important source of financing. The cost of trade credit depends on the terms of credit offered by the supplier. When the supplier offers discount for prompt payment, trade credit availed beyond the discount period is quite costly

Working capital advance by commercial banks

• Working capital advance by commercial banks represents often the most important source for financing current assets. It is provided in different ways: (i) cash credits/overdrafts, (ii) discount of bills.

Public deposites

• Many firms, large and small, have received deposits from the public. The maximum maturity period allowed for public deposits is three years for manufacturing companies and five years for finance companies.

Inter corporate deposites

• A deposit made by one company, with another, normally for a period up to six months is referred to as an inter-corporate deposit.

Commercial paper

• Represents short-term unsecured promissory note issued by firms, which enjoy a fairly high credit rating.

Factoring

• involves sale of accounts receivable to a factor who charges a commission on it.

Thank Q