WORKING CAPITALPlanning and Management

VINITA TANEJA B.COM(H) 3RD YEAR

MADE BY

Introduction to Working Capital Management• The term working capital refers to current assets which may

be defined as (i) those which are convertible into cash or cash equivalents within a period of one year, and (ii) those which are required to meet day to day operations.

• Working Capital Management is management of firm’s sources and uses of working capital in order to maximize the wealth of the shareholders .

Term Working Capital-two different ways• GROSS WORKING CAPITAL : • It refers to the firm’s investment in all the current assets taken

together.• NET WORKING CAPITAL : • The term net working capital may be defined as excess of total

current assets over total current liabilities.

• Excess of current assets over current liabilities are called the net working capital or net current assets.

• Working capital is really what a part of long term finance is locked in and used for supporting current activities.

• The balance sheet definition of working capital is meaningful only as an indication of the firm’s current solvency in repaying its creditors.

• When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources.

• In fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds.

Operating Cycle• The operating cycle may be defined as the time duration

starting from the procurement of goods or raw materials and ending with the sale realization.

• The operating cycle of a firm consists of the time required for the completion of the chronological sequence of some or all of d following

• Procurement of raw materials & services.• Conversion of raw materials into work-in-progress.• Sale of finished goods (cash or credit)• Conversion of receivables into cash.

OPERATING CYCLE PERIOD= Inventory Conversion period + Receivables Conversion Period

Inventory Conversion Period: It is the time required for the conversion of raw materials into finished goods sales. ICP= RMCP+WPCP+FGCP.

Receivables Conversion Period: It is the time required to convert the credit sales into cash realization. It refers to the period between the occurrence of credit sales and collection of debtors.

Calculation of TOCP & NOC

RMCP ----Days

+WMCP ----Days

+FGCP ----Days

+RCP ----Days

TOCP ----Days

-DP ----Days

NOC ----Days

RMCP= Average raw material stock 365 Total raw material consumption

WPCP= Average work in progress 365 Total cost of production

FGCP= Average finished goods 365 Total cost of goods sold

RCP= Average Receivable 365 Total Credit Sales

DP = Average Creditors 365 Total Credit Purchase

RMCP WPCP FGCPReceivable Conversion Period

Inventory Conversion Period

Deferral Period

Net Operating Cycle

THE OPERATING CYCLE

EXCESS OR INADEQUATE WORKING CAPITAL•

Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital.

Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.

Disadvantages of Redundant or Excess Working Capital•

Idle funds, non-profitable for business, poor ROI• Unnecessary purchasing & accumulation of inventories over

required level • Excessive debtors and defective credit policy, higher incidence

of B/D.• Overall inefficiency in the organization.• When there is excessive working capital, Credit worthiness

suffers• Due to low rate of return on investments, the market value of

shares may fall

Disadvantages or Dangers of Inadequate or Short Working Capital

• Can’t pay off its short-term liabilities in time. • Economies of scale are not possible.• Difficult for the firm to exploit favorable market situations • Day-to-day liquidity worsens• Improper utilization the fixed assets and ROA/ROI falls sharply

Different types of working capital policies

• Moderate Working Capital Policy : The increase in sales level is coupled with proportionate increase in level of current assets.

• Conservative working capital policy: For every increase in sale there is more than proportionate increase in current assets. It reduces the risk of shortage of working capital by increasing the safety component of current assets.

• Aggressive working capital policy: the increase in sale does not result in proportionate increase in current assets. It lead to risk of insolvency & difficulty to face unexpected changes. Reduced investment in current assets, result in increase in profitability of the firm.

Types of Working Capital Needs• Permanent working capital: the minimum level of working

capital which is constantly required by a firm in order to maintain its activities irrespective of the level of activities. Even during slack season, every firm maintains some current assets.

• Temporary working capital: The working capital required over and above the permanent working capital to meet the requirements arising out of fluctuations in sales volume

Difference between permanent & temporary working capital

Amount of working capital

Permanent working capital

Variable working capital

Time

Amount of working Capital

Time

Permanent Working Capital

Variable Working Capital

Financing of Current Assets• An important aspects of working capital management is to

decide the pattern of financing the current assets and one of the major problem in working capital management is the decision whether to finance the working capital with one source or the other. Breaking down working capital needs into permanent and temporary components over time provides a useful by product in terms of financing choice.

• So the two components of working capital needs to be finance accordingly for which the different sources of fund can be grouped as follows.

1. LONG TERM SOURCES These provides fund for a relatively longer period. Major long term sources:

• Share capital • Retained earning • Debentures• Long term borrowings2. SHORT TERM SOURCESThese provide funds for a short period say up to one year or so Major short term sources:• Bank credit• Pubic deposit• Commercial papers• Factoring3. TRANSACTIONARY SOURCESThese provide funds to a business through the normal business operationsMajor sources:• Credit allowed by suppliers• Outstanding labor• Other expenses

Approaches related to financing mix

Hedging Approach: Fixed working capital is financed by long term sources of funds while the additional or fluctuating working capital needs are financed by short term sources

Amount of WC

Long term sources

Short term sources

Total WC

Conservative Approach• Working Capital needs are primarily financed by long term

sources and the use of short term sources may be restricted to unexpected and emergency situation only.

Time

Amount of WC

Total WC

Long term sources

Aggressive Approach

• The firm decide to finance a part of the permanent working capital by short term sources. So, the short term financing under the aggressive policy is more than the short term financing under the hedging approach. It seek to minimize excess liquidity while meeting the short term requirements.

Amount of WC

Long term sources

Total WC

Permanent WC

Short term financing

Working Capital: Monitoring & Control

• Monitoring the operating cycle: The actual operating cycle period should be ascertained for each element that is the raw material, WIP, Finished goods etc. over a period of time and should be compared with the standard operating cycle period set for the same firm or for the industry as a whole.There should always be an attempt to reduce the length of the operating cycle.Efforts in particular are needed to control the receivable conversion period.

Working Capital Ratios• Another analytical tool that can be used to monitor the

working capital is the accounting ratios, mainly the working capital ratios.

1. Current ratios: CA/CL2. Liquid ratio: quick assets/CL3. current assets to total assets ratios.4. Current assets to total sales ratios.

FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTSFactors to be considered• Total costs incurred on materials, wages and overheads• The length of time for which raw materials remain in stores before

they are issued to production.• The length of the production cycle or WIP, i.e., the time taken for

conversion of RM into FG.• The length of the Sales Cycle during which FG are to be kept waiting

for sales.• The average period of credit allowed to customers.• The amount of cash required to pay day-to-day expenses of the

business.• The amount of cash required for advance payments if any.• The average period of credit to be allowed by suppliers.• Time – lag in the payment of wages and other overheads

Estimation of Working CapitalCurrent Assets Amount Amount Amount

I Minimum Cash BalanceInventories : Raw material WIP Finished goodsReceivables: Debtors BillsGross working capitalII Current liabilities:

Creditors for PurchasesWagesOverheadTotal Current LiabilitiesExcess of CA over CL+ Safety MarginNet working capital

Meaning of Cash Management

• Cash management refers to management of cash and bank balance, or in a broader sense it is the management of each inflows and outflows. In ordinary parlance cash implies ready money or its equivalent. However, Management Accountants define cash as the most liquid assets, need to carry out the day-to-day activities of the business. For cash management purposes, the term cash is used in broader senses i.e., it covers cash, cash equivalents and those assets which are immediately convertible into cash.

• It is the duty of finance manger to have liquidity at all parts of the organization while managing cash

• He has also to ensure that there are no funds blocked in idle cash. Idle cash resources entail a great deal of cost in terms of interest charges and in terms of opportunities costs.

• A cash management scheme therefore, is a delicate balance between the twin objectives of liquidity and costs.

Objectives of Cash Management

• Meeting the cash outflows and minimizing the cost of cash balance.• Management of cash is an important function of modern business.

The main objective of cash management is to determine the optimal cash balance i.e., a balance which is neither in excess not inadequate because idle cash produce nothing and shortage cash affects firm’s liquidity. Thus, the objectives of cash management are two fold;

• to meet the disbursement needs, and • to minimize funds committed to cash balances.• The task of cash management is to reconcile these two conflicting and

mutually contradictory aspects. The idle cash should be invested in temporary securities so as to earn some return and shortage of cash should be arranged by raising short-term loans. Thus, cash management is concerned with management of cash affairs in such a way that gives the least possible cost of maintaining cash. The objective is maximizing profitability without sacrificing liquidity.

The Need for Cash

• The following are three basic considerations in determining the amount of cash or liquidity as have been outlined:

• 1.Transaction need: Cash facilitates the meeting of the day-to-day expenses and other debt payments. Normally, inflows of cash from operations should be sufficient for this purpose. But sometimes this inflow may be temporarily blocked. In such cases, it is only the reserve cash balance that can enable the firm to make its payments in time.

• 2. Speculative needs: Cash may be held in order to take advantage of profitable opportunities that may present themselves and which may be lost for want of ready cash/settlement.

• 3. Precautionary needs: Cash may be held to act as for providing safety against unexpected events.

Managing Cash Collection and Disbursements

• (a) Speed up the mailing time of payments from customers;• (b) Reduce the time during which payments received by

the firm remain uncollected and speed up the movement of funds to disbursement banks.

(i) Concentration Banking: • Collection center are opened as near to the debtors as

possible, hence reducing the time in dispatch, collection etc.• The firm may instruct the customers to mail their

payment to a regional collection Centre rather than to the central office.

(ii) Lock Box System: 1. To eliminate the time between the receipt of remittances by the company

and deposited in the bank. 2. Under this arrangement, the company rents the local post-office box and

authorizes its bank at each of the locations to pick up remittances in the boxes.

3. The bank picks up the mail several times a day and deposits the cheques in the company’s account. The cheques may be micro- filmed for record purposes and cleared for collection.

4. The company receives a deposit slip and lists all payments together with any other material in the envelope.

5. This procedure frees the company from handling and depositing the cheques.

6. The main advantage of lock box system is that ‘lag between the time cheques are received by the company and the time they are actually deposited in the bank is eliminated.

7. The main drawback of lock box system is the cost of its operation. 8. Lock box arrangements are usually not profitable if the average remittance

is small.

Managing the FloatWith reference to the control of inflows and outflows, float is an important technique to lessen the length of the cash cycle. So when a firm receives or makes payments in the form of cheques etc., there is usually a time gap between the time the cheque is written and when it is cleared. This time gap is known as float. The float of the paying firm refers to the time that elapses between the point when it issues a cheque and the time at which the funds underlying the cheque are actually debited in the bank account. For the payee firm, float refers to the time between the receipt of the cheque and the availability of the funds in its account. Float has 3 components:

(i) Mail Time : It is the period between the issue of a cheque and its receipt by the payee.

(ii) Processing Time : It is the time between the cheque received by the payee and the deposit of the cheque in the bank account of the payee, and

(iii) Collection Time : It is the amount of time for transferring funds, through banking system, from the payer’s account to that of the payee. In India, this collection time is generally three days, including the day of depositing a cheque.

Cash budget:

• Cash budget represents cash requirements of business during, the budget period. It is the plan of receipts and payments of cash during the budget period. Cash budget can be prepared for short period or for long period.

• • Purpose of cash budget• Cash budget is a device for planning and controlling the inflows &

outflows of cash the ensure the availability of cash when it is needed• • As regards receipts

1. Receipts from debtors;2. Cash sales and;3. Any other sources of receipts of cash (say, dividend from a subsidiary

company).

• As regards payments

1. Payments to be made for purchases;2. payments to be made for expenses; 3. payments that are made periodically but not every

month;a. debenture interest;b. income tax paid in advance;c. sales tax etc.

4. Special payments to be made in a particular months, for example, dividends to shareholders, redemption of debentures, repayments of loan, payment for assets acquired etc.

• The following forcast has been made for ABC Ltd

• • All sales are made on credit basis. 2/3 of debtors are collected in the same

month and balance in the next month. There is no expected bad debts. The debtors on jan 1, 2014 were Rs. 30000.

• The minimum cash balance is Rs 5000. cash balance on jan 1 is 65000.• Borrowing if any made in multiples of 100

January feb march aprilsales 75000 105000 180000 105000Raw material

70000 100000 80000 85000

Manufacturing expenses

10000 20000 29000 16000

instalment 1000 11000 21000 21000

EXAMPLE

SOLUTIONjan feb march april

Opening cash 6500 5500 5000 5000

Debtors previouscurrent

3000050000

2500070000

35000120000

6000070000

Total cash(A) 86500 100500 160000 135000

Raw materialManufacturing expenseinstallment

7000010000

1000

10000020000

11000

8000029000

21000

8500016000

21000Total outflows(B)

81000 131000 130000 122000

Cash balance(A-B)

5500 -30500 30000 13000

Borrowing(refund)

35500 -25000 -8000

Baumol’s Model of Cash Management • William J. Baumol developed a model for optimum cash balance

which is normally used in inventory management. The optimum cash balance is the trade-off between cost of holding cash (opportunity cost of cash held) and the transaction cost (i.e. cost of converting marketable securities in to cash held) . Optimum cash balance is reached at a point where the two opposing costs are equal and where the total cost is minimum. This can be explained with the following diagram:

Optimum Cash Balance

Total cost

Holding Cost

Transaction cost

Cost (Rs.)

• The optimum cash balance an also be computed algebraically

• A = Annual Cash disbursements.• T = Transaction cost (Fixed cost) per transaction• H = Opportunity cost one rupee per annum

(holding cost)

Optimum Cash Balance = 2AT

H

The model is based on the following assumptions: Cash needs of the firm are known with certainty. The cash is used uniformly over a period of time and it is

also known with certainty The holding cost is know and it is constant The transaction cost also remains constant.

Miller-Orr Cash Management model• According to this model the net cash flow is completely

stochastic. When changes in such balance occur randomly, the application of control theory serves a useful purpose. The Miller – Orr model is one of such control lime it models. This model is designed to determine the time and size of transfers between and investment account and cash account. In this model control limits are set for cash balances. These limits may consist of ‘h’ as upper limit, ‘z’ as the return point and zero as the lower limit.

Lower Control Limit

Return Point

Upper Control Limit

Time

Cash Balance

(Rs.)

H

z

0

• When the cash balance reaches the upper limit, the transfer of cash equal to ‘ h – z’ is invested in marketable securities account. When it touches the lower limit, a transfer from marketable securities account to cash account is made. During the period when cash balance stays between (h, z) and (z, o) i.e. high and low limits, n transactions between cash and marketable securities account is made. The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transaction, the opportunities cost of holding cash and degree of likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible total costs.

Inventory Management

• Inventory management means planning, organizing, directing & controlling of inventory. The basic objective of inventory management is to place an order for material

• at the right time • for the right source • to acquire the right quantity • at right place and • of right quality.

INVENTORY MANAGEMENT

Inventories constitute a major element of working capital. Inventory management covers a large number of problems including:

a. fixation of minimum and maximum levels, b. determining the size of inventory to be carried, c. deciding about the issues,d. receipts and inspection procedures,e. determining the economic order quantity, f. proper storage facilities, g. keeping check over obsolescence and ensuring control over

movement of inventories

• Meaning • Inventory means stock of goods that is maintained to

facilitate the continuous production of goods and services. Investment involves the commitment of firm’s resources. If the inventories are too big, they become a strain on the firm’s resources. However, if they are too small, the firm may lose the sales. Therefore, the firm must have an optimum level of inventories.

Objective of inventory management

To avoid the situation of excessive and inadequate inventory and

To determine and maintain optimum level of inventory After achieving a trade off between the profitability and

liquidity So as to maximize the wealth of shareholders as a whole

Excessive inventory Inadequate inventory

1 Opportunity cost of funds tied up in inventory

Interruption of production

2 Excessive carrying cost eg. Storage cost, insurance cost, handling cost etc.

Excessive stock out cost

3. Risk of liquidity

Need for holding inventory

1. Transaction motive• Sufficient stock of raw material is to be held by the stores so as to ensure continuous

and uninterrupted supply of raw material to production• Sufficient stock of WIP is to be held due to production cycle• Sufficient stock of finished goods is to be held to facilitate continuous supply of

product to customers

2. Precautionary motive• To hold inventory to meet contingencies

3. Speculative motive• To hold inventory in order to take advantage of profitable opportunities.

Types of Inventory

• Raw materials: the raw materials inventory consists of goods which are to be converted into finished goods through the manufacturing process.

• Work-in-progress: It refers to the raw materials engaged in various phases of production process. The degree of completion may be varying for different units. Some units might have been just introduced, while some others may be 40% complete others may be 90% complete. The work-in-progress refers to semi-finished goods. The quantity and the value of work-in-progress depend on the length of the production cycle.

• Finished Goods: Finished goods consist of final products which are ready for sale.

Economic order quantity/ reorder quantity The quantity for which order is placed when the stock reaches

reorder level Quantity which is most economical to order The quantity of inventory, at which total of ordering costs and

carrying costs is minimum.Ordering costs refers to the cost incurred for acquiring material i.e. inputs. These costs include:-• cost of placing an order• cost of transportation• cost of receiving goods • cost of inspecting goods There is an inverse relationship relationship between order size and ordering cost .

• Carrying cost refers to the cost incurred in maintaining a given level of inventory. These costs include:-

• cost of storage space• cost of handling material• cost of insurance • cost of deterioration or obsolescence• cost of store staffThere is positive relationship between order size and carrying cost.Assumptions:

Ordering cost per order & carrying cost per unit, per annum are given & they are fixed.

Usage of material in units is known. Cost p.u of material is constant & is known. The quantity of material ordered is lead immediately i.e. lead

time zero.

• Determination of EOQ

• There are three methods for determination of EOQa) Graphical method b) Tabular method c) Formula method

Graphical method

Total cost

Holding Cost

Ordering cost

Cost (Rs.)

EOQ

Particulars Order size I Order size II

a. Annual consumption X Xb. Order size X Xc. No. of orders X Xd. Cost per order X Xe. Total ordering cost X Xf. Average inventory X Xg. Carrying cost per unit X Xh. Total Carrying cost X Xi. Total cost X X

Tabular method/ trial & error method

• Formula method

• The optimum cash balance an also be computed algebraically

• A = Annual Requirement • O = Ordering cost• C = Carrying cost

Optimum Cash Balance = 2AO

C

ABC Analysis

• This technique is based on selective control of inventory. Under this technique various item of inventory are classified into three group of priority and allocates managerial efforts in proportion of the priority. The most important items are Classified as Class A, those of intermediate importance are classified as Class B and the remaining items are classified as Class C. in other words, under this system, all items of inventory are categorized according to their value significance:

• ‘Category A’ includes high value, low volume items. These constitute only a small percentage share in the total value of inventory.

• ‘Category B’ includes medium value items. Their percentage share in total quantity is nearly equal to their percentage share in the total value of inventory.

• ‘Category C’ includes low value, high volume items. Their percent-age share in total quantity of inventory is very large, bur their percentage share in the total value of inventory is small.

Material Categories

% share in total value of total inventories

% share in total quantities – units, weight or volume of total inventory

A (High value, Low volume)

70 10

B (Medium value) 20 20

C (Low value, High volume)

10 70

Total 100 100

On the basis of physical quantities and value of material used a table as follow may be constructed.

‘Category A’ item represent 70% of the total value of total inventories but 10% of total quantity of inventory. Maximum control must be exercised on this category. ‘Category C’ comprising 70% in quantity but only 10% in value, needs a simple and economic system of control.

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