WORKING CAPITAL MANAGEMENT

Meaning Capital required for a business can be classified into two:

1. Fixed capital – for purchase of fixed assets- long term

2. Working capital – to meet day-to-day operations of the business like purchase of raw material, payment of wages, etc – short term.

Definitions1. “Working capital is the amount of funds necessary to cover the cost of

operating the enterprise.” – Shubin

2. “Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another as for example, from cash to inventories, inventories to receivables and receivables into cash.” - Genestenberg

Concept of working capital

Gross concept – Broad sense – amount invested in current assets which can be converted in to cash within one year.

Net concept – Narrow sense – excess of current assets over current liabilities (CA-CL). May be positive or negative. If CA exceed CL positive, otherwise negative.

Current Assets 1. Cash in hand and bank balance2. Bills receivables3. Sundry debtors4. Short term loans and advances5. Inventories of stock as raw material, WIP,

stores and spares and finished goods6. Temporary investment7. Prepaid expenses8. Accrued income – eanred but not received

Current Liabilities1. Bills payables

2. Sundry creditors

3. Accrued or outstanding expenses

4. Short term loans and advances

5. Dividend payable

6. Bank overdraft

7. Provision for taxation

Kinds of working capital On the basis of concept

a.Gross WC

b.Net WC

On the basis of time

a. Permanent or fixed WC

b. Temporary or variable WC

Permanant or Fixed WC It is the minimum amount which is required to ensure effective utilization of

fixed facilities and always a fixed minimum level for smooth working of the firm.

eg: minimum cash balance, raw material balance, etc

Two types

1. Regular WC – for regular use

2. Reserve WC – for meeting contingencies- unexpected

Temporary or variable WC For meeting seasonal demand. During a particular season

wc will be required at large level.

Two types

1. Seasonal WC – for meeting seasonal needs

2. Special WC – for meeting special needs like market research, campaigns, etc

Need and importance of WC1. Solvency of the business2. Goodwill3. Easy loans4. Cash discount5. Regular supply of raw material6. Regular payment of salaries, wages, etc.7. Exploitation of favourable market conditions8. Ability to meet crisis9. High morale10. Quick and regular return on investment

Excess or inadequate working capital

Every business organization should have adequate working capital to run its business operations. It should have neither excess nor inadequate. Both excess and shortage will affect the firm adversely. However, out of these shortage of working capital is more dangerous.

Dangers of excess working capital

1. Excess means idle funds which earn no profits for the business and hence the business can not earn a proper rate on its investment.

2. Leads to unnecessary purchase and accumulation of inventories and causing more chances of theft, waste and losses.

3. Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts.

4. Leads to overall inefficiency of the organization5. Relation with banks and other financial institutions may

not maintained.6. Due to low rate of return on investments, the value of

shares may also fall.

Dangers of inadequate working capital

1. Can not pay short term liabilities in time. Thus it will loss reputation of the firm.

2. Can not buy its requirements in bulk, and can not avail discounts.

3. Can not exploit favourable market conditions and can not undertake profitable projects.

4. Can not pay day-to-day expenses.5. Can not use efficiently the fixed assets6. The rate of return on investments also fall and share

value will be reduced.

Factors affecting working capital requirements

1. Nature of the business – public utilities (low working capital) and manufacturing concerns (high working capital)

2. Size of the business

3. Proportion of raw material cost to total cost – eg: sugar industries

4. Nature of industry – labour intensive – more working capital and capital intensive – less working capital.

5. Time lag in production

6. Need for stock pilling – eg: seasonal industires

7. Requirements of cash

8. Relation with banks

9. Policy regarding dividend

10. Seasonal variations

11. Cyclical fluctuations

12. Other factors like transportation facilities, communication facilities, etc.

Sources of working capital

Fixed working capital – shares, debentures, public deposit, retained earnings, etc.

Variable working capital – commercial banks, advances, trade credit, accounts receivables, etc.

Working capital cycle It is also called operating cycle, cash cycle and working cycle.

Different forms of conversion of cash

Diagramcash

WIPFG

InventorySales

Debtors

Receivables Management

Receivables represents amounts owned to the firm as a result of sale of goods or services in the ordinary course of business.

These are claims of the firm against its customers and form part of its current assets.

It is also known as accounts receivables, trade receivables, customer receivables or book debts.

Features It involves an element of risk – chance of bad debts

It is based on economical value – for maximum profit

It implies futurity

Cost of maintaining receivables

1. Cost of financing receivables – allowed the customers to use the shareholders fund

2. Cost of collection – cost incurred as reminders, legal steps, etc

3. Bad debts – some customers may failes to pay

4. Administrative cost – salary, energy, etc

5. Production and selling cost

Credit policy “The term credit policy is used to refer to the combination of three

decision variables:

1. Credit standards2. Credit terms3. Collection efforts”

Types Lenient – credit sales on liberal terms and standards and for long period

Stringent – credit sales on highly selective basis and for short period without considering personal aspects.

In practice, firms follow stringent to lenient

Optimum credit policy Optimum credit policy is one which maximises the firms value. Value of the firm maximised only when the incrimental rate of return of an investment is equal to the incrimental cost of funds used to finance investment.

Credit policy variables1. Credit standards and analysis

2. Credit terms

3. Collection policy and procedures

Credit standards The term credit standard represents the basic criteria for the extension of credit to the customers. If the credit standard of the organisation is a right one, there will not any bad debt losses and less cost of credit administration.

Credit analysis Credit standard influence the quality of the firms

customers. There are two aspects of the quality of the customers.

1. Time taken by customers for payment2. Default rate Probability of default rate depends upon 5 C’s1. Character – customers willingness to pay2. Capacity – ability to manage the business3. Capital – financial soundness4. Collateral – assets, which is offered by customer as a

security for the credit he receives5. Conditions – impact of general economic conditions on

the firm.

On the basis of analysis, customers can grouped into three catagories:

1. Good account – financially strong customers

2. Bad account – financially very weak

3. Marginal account – moderate financial health

Credit terms Terms and conditions depends upon manager’s policies, attitudes, etc.

Collection policy and procedures

A collection policy is necessary to accelerate slow and non payers to quick payments.

Only through a good collection policy we can ensure a prompt payment from our parties.

Inventory management Inventories are one of the current assets.

If the size is large, a large amount of investment is there.

Consist of raw materials, WIP, finished goods and suppliers or stores and spares like brooms, lights, etc.

Needs or motives to hold inventories

1. Transaction motive – for smooth production inaccordance with demand

2. Precautionary motive – to guard against unpredictable changes in demand and supply

3. Speculative motive – for taking adavantages of price fluctuations.

Inventory management techniques

Managing inventories should be based on the objective of shareholder’s wealth maximization.

For efficient management of inventories, we have to find out the answers of two questions-

1. How much should be ordered? and

2. When should it be ordered?

EOQ – Economic Ordering Quantity

Answer of first question is EOQ.

Economic Ordering Quantity is that inventory level which minimises the total ordering and carrying cost.

EOQ = root of 2CO divided by I

Where C = annual consumption

O = ordering cost per unit

I = carrying cost per unit

Re-order point Answer to the second question is Re-order point. “The re-order point is that inventory level at which an order should be placed to replenish the inventory”.

Re-order point = Lead time x avg usage + safety stock

Lead time : the time normally taken to replenish the inventory after the order has been placed.

Safety stock : minimum level of stock maintained by the organisation to guard against the stock-out.

Inventory control ABC Analysis

VED analysis

FSN analysis

ABC Analysis The firm has to classify the inventories on the basis of their value.

There is no need for same control over all the inventories.

High level items valued as ‘A’ – need highest control

Least value items valued as ‘C’ – need simple control

In between A & C as ‘B’ – need reasonable attention

VED Analysis Used to control the spare parts Spare parts are classified into three catagories:1. Vital – those spares which are vital for the continuous

production. Their stock-out will stop the production.2. Essential – essential for continuous production. Their

stock-out for more than a few hours or a day will result in much loss

3. Desirable – desirable for production but their stock-out even for a week will not result in stoppage of production.

FSN Analysis Materials are classified into three:

1. Fast moving items – which are consumed very rapidly

2. Slow moving items – which are not consumed frequently

3. Non-moving items – which are rarely used.

Cash Management Major function of a financial manager is to maintain a sound cash balance.

Management of cash inflows and outflows.

Motives of holding cash1. Transaction motive – for all transactions like purchases,

salary payment, etc.

2. Precautionary motive – to meet contingencies in future.

3. Speculative motive – for using the favourable conditions.

Strategies for proper cash management1. Cash planning

2. Managing the cash flows

3. Optimum cash level

4. Investing surplus cash

1. Cash planning Cash planning is a technique to plan and control the use of cash.

For proper planning preparation of both long term and short term cash budget is essential.

Cash budget is a summary statement of firm’s expected cash inflows and outflows over a projected time period.

2. Managing the cash flows After preparing the budget, financial manager and the

organization will try maximum to achieve the budget.

Objectives are:

1. Accelerate cash collections

2. Decelerate cash disbursements

Accelerating cash collections An organization should speed-up its cash collections.

An efficient financial manager can take attempts to reduce the firm’s floats by speeding up the mailing process and collection time.

Float – it is the difference between the company’s bank balance and the balance shown in the bank’s book of the firm.

Methods for accelerating cash inflows

1. Decentralised collections/concentration banking

2. Lock-box system-eliminate the time gap between collection of cheques and deposit into bank

3. Prompt payment by customers – by sending self addressed envelops along with the bill

Decelerate cash disbursements

There is no advantage in paying sooner than agreed.

But delayed payment will be a source of finance.

Methods for slowing cash outflows

1. Paying on last date

2. Payments through account payee cheque

3. Centralised payment

4. Inter-bank transfer

5. Salary payment through cheque

3. Determination of optimum cash balance One of the primary responsibility of the financial manager is to maintain a sound liquidity position of the firm.

Liquidity – sufficient funds to meet firm’s requirements as well as emergencies.

Profitability – capacity of the firm to utilize the fund for profitable projects.

If liquidity is greater , lesser the profitability.

Therefore the cash balance should be optimum.

Question of how to determine optimum cash balance under certainty & uncertainty?

Optimum cash balance under certainty – Baumol’s Model

(note)

Optimum cash balance under uncertainty – Miller Orr Model

(note)

4. Investment of surplus fund

Should be used in liquid and risk free securities like:1. Treasury bills – issued by RBI on behalf of Central

Govt.2. Certificate of Deposit3. Unit 1964 Scheme – open-ended scheme with a face

value of Rs.10 for each unit.4. Inter-corporate deposits5. Bill discounting6. Money Market Mutual Fund7. Ready Forwards – banks sells and repuchase

the securities at a pre-determined price.8. Badla financing – financial assistance to brokers

in the Stock Exchange.